This article provides complete guide to special drawings rights.
Special Drawings Right-Paper Gold:
Gold has been replaced by a new international reserve asset called Special Drawing Rights (SDRs).
It will perform all the functions of gold or gold standard without facing the limitations of the same.
It was the result of a slow and gradual evolution of the discussion of many master minds in the field of international monetary economics.
It has been described as ‘paper gold’. It was approved in principle at the Fund’s annual meeting at Rio de Janeiro in September 1967. The Articles of Agreement of the Fund were amended with effect from July 28, 1969, to authorize the Fund to allocate SDRs to its members in proportion to their quotas, in order “to meet the need, as and when it arises, for a supplement of existing reserve assets”.
The SDRs scheme, however, came into actual operation only from January 1970. The scheme as adopted by the IMF is the integrated development of the ideas of Keynes, vision of Triffin, Bernstein and others in the 1950s and the long drawn official discussions of the 1960s which eventually gave birth to the new reserve asset called SDRs.
The main features are as follows:
(i) The SDR consists of a credit created or established in the books of the Special Drawing Rights Department of the Fund in favour of the member. These credits are created on the occasion of an allocation and are provided in proportion to members’ quotas.
(ii) The creation of SDRs is essentially similar to the concept of credit creation by the central banks within the country. The main feature of the new plan is the principle for the conscious creation of man-made reserves to supplement gold. SDRs do not accrue to the Fund in the first instance, but these are, deliberately created by the Fund on behalf of the participants according to the needs.
(iii) These rights are designed to meet the need as and when it arises for the settlement of international balances. Their use in the beginning and on priority basis is expected to be confined to those countries which are suffering from the balance of payments difficulties.
(iv) The scheme is general, universal and non-discriminatory in character because it confers same benefits on all.
(v) There is no compulsion to repay earlier borrowings from the IMF while drawing on SDRs. Repayments or reconstitution of the reserves (SDRs) which have been used will be necessary only in the case of the use beyond 85 per cent of the average allocation over the preceding five years. To this extent, the unconditional character of the new facility is confirmed. In other words every country is obliged to keep on an average at least 15 per cent of its SDRs in its own reserves. If in a year it spends more, it must spend less in the following year. Even this 15 per cent may be abolished in future.
(vi) All the decisions regarding the creation of SDRs will require an 85 per cent majority of the voting power of the participants. The SDRs will be issued for a basic period of five years in regulated amount each year. The basic period may also be an empty period when no allocations are made. In the first basic period 1970-72, SDRs 9.3 billion was allocated; in the second basic period 1973-77, no SDRs were allocated; and in the third basic period 1978-81, SDR 12.0 billion was allocated.
The Fund has allocated a total of SDR 21.4 billion equal to or about US $ 25.5 billion by 1987 since its creation. They constitute about 6 per cent of total non-gold reserves by 1988. Not all the members of IMF need be participants, there is liberal scope for opting in and opting out. Members can opt in during the operation of a basic period and receive allocation.
(vii) SDRs are expected to be used to meet the balance of payments needs and not for the sole purpose of changing the composition between SDRs and gold or foreign exchange or reserve position in the Fund. Although SDRs will figure in the published reserves of a country along with gold, foreign exchange and the gold tranche of its quota in the Fund (where it has not already been drawn), these reserves of SDRs cannot be spent direct on goods and services. Under the rules, a country can normally use its SDRs if it is in balance of payments difficulties.
(viii) The basic obligation of a member is to provide its own currency when requested to the Fund, up to a total of three times its own allocation of SDRs. A modest rate of interest will be paid in SDR on holdings of such drawing rights by the Fund, which will charge it from countries using SDRs. The Fund pays interest to holders of SDRs, and members pay interest to the Fund on their allocations of SDRs at the same rate. Thus, a member that holds SDRs in amounts equal to its allocation receives exactly as much interest as it pays. Thus, it is costless lines of credit.
(ix) With the introduction of SDR scheme, there will be two accounts in the IMF:
(a) The general account,
(b) The special drawing rights account.
The general account deals with ordinary drawing rights already existing and ordinary transactions of the IMF relating to quotas, drawings, subscription, interest charges, etc. The SDR account will deal with SDRs. The best way to understand the scheme is to think of the rights as pieces of papers which other countries will accept in payment of debt—that is, paper gold.
In other words, these rights are just like coupons which can be exchanged for currencies required by the holder of SDRs for making international payments. However, they are not pieces of paper like bank notes or treasury bills, they are simply entries in the SDR account of IMF. Initially, at least the Fund will not itself possess any of the new assets.
Valuation of SDRs:
According to the SDR scheme, it will be a sort of gold paper. The value of SDR was fixed in gold. The value of the SDR being fixed had to be maintained by the member countries one SDR = one US dollar’s worth of gold at the then official rate of 35 an ounce or 0.888671 grams fine gold. But its link with gold has been given up.
The SDR is now defined in terms of a basket, or collection, of the five major currencies of the world: the US dollar, the Deutsche mark, the Japanese yen, the French franc and the pound sterling. The value of the SDR at any given time in terms of a given currency may be calculated by using the exchange rates of the constituent currencies against the dollar and the rate of the given currency against the dollar.
A new system of valuation, thus, replaced the previous system under which the SDR was valued in terms of gold or US dollar. As such, the SDR began to assert as a unit of account. The Fund decided from January 1981 to have a ‘standard basket’ of 5 currencies only instead of 16 currencies as was the case earlier.
The new unified ‘standard basket’ will compose of the currencies of any 5 member countries having the largest export of goods and services during the last five years and widely used in world trade and payments period. At present these are the US dollar Deutsche mark, Japanese yen, French franc and pound sterling.
The value of the SDR will be equal to the sum of the values of these currencies weighted as US dollar 42 per cent, Deutsche mark 19 per cent, Japanese yen 15 per cent, French franc 12 per cent and Pound Sterling 12 per cent.’ Because SDRs’ now comprise the dollar, mark, yen, franc and pound sterling, any fluctuation in one currency would be outweighed by gains in another thus making the new instrument (of SDR) a stable investment thereby enhancing its role as an international asset. At present one unit of SDR = $ 1.30 approximately and increased to 1.38 in May 1988.
According to Fund sources one great use of the change over to the five currency standard basket will be that all exchange rates used for calculating the value of SDRs will be obtained by the IMF from the London market [for example, the US dollar rate for the Japanese yen used in daily calculation will be obtained from now on (1981 onwards) from London Exchange Market rather than the Tokyo Exchange Market].
As such, it will be easier for banks or other holders of SDR denominated deposits to replicate the SDR in the private market when they need to do so. Such a stability in value is a desirable characteristic of a reserve asset and a unit of account.
Mechanism of SDRs:
The mechanism of operating SDRs has been evolved. Under this scheme, a country (say A) needs convertible foreign exchange resources—it has to apply to the Fund for the use of SDRs (in other words, it draws on its SDR account with the Fund).
It can use or draw its SDRs up to the limit of allocated amount. The Fund, on receiving such an application from the member world designate another country (say B), whose balance of payments and gross reserve position are quite strong— called the designated country—to meet the foreign exchange requirements of country A. After designation by the Fund, the country A can draw on the designated country B a total net amount equal to thrice the amount of SDRs allotted to the designated country.
For example, suppose country A has been allotted an SDRs quota of 1,000 units and the designated country B has been allotted a quota of 1,500 units. Suppose, country A needs convertible foreign exchange of 500 units for which country B has been designated by the Fund. The country A has to part with 500 units of SDRs holding and give them to country B in exchange for an equivalent amount of foreign exchange reserves. Country A becomes a debtor and country B a creditor.
To debtor country A has to pay interest at 1.5 per cent per annum on the units surrendered to the creditor country B. It may be noted that the designated country cannot be asked to provide foreign exchange against SDRs in excess of thrice the quota of SDRs allotted to it (i.e.. 1,500 x 3 = 4,500 units).
In case country A wants more than thrice the amount allotted to the designated country B, some other countries along with this country B will have to be designated to meet the total requirements. Thus, a country which decides to use SDRs informs the IMF, the Managing Director of the Fund then designates another country with large surplus or reserves—as its partner in the SDR—currency swap.
IMF Ordinary Drawing Rights versus Special Drawing Rights (ODRs versus SDRs):
However, SDRs are quite different from the ordinary drawing rights already in existence for the last over 45 years or so. The main difference is that SDRs are available automatically, whereas IMF had to be satisfied as to the fulfillment of certain conditions in case of the use of ordinary drawing rights.
The latter used to arise as a by-product of gold subscriptions to the Fund but SDRs are deliberately created in amounts considered necessary to meet the need as and when it arises for a supplement to the growth of world reserves.
The SDRs add permanently towards reserves in a way that the conventional or ordinary drawing rights do not. For example, when Britain makes a conventional 25 million drawing on the IMF, it pays in that amount sterling in exchange for foreign currency and at the end of three to five years has to reverse the transaction. This was the position before SDRs came into operation.
Under the SDR scheme, Britain will transfer 25 million of its SDRs to say, Germany, for marks. Britain’s holdings of SDRs will fall and Germany’s holdings of SDRs would rise accordingly. Germany having been designated by Fund will provide marks to that extent.
Thus, the great merit of SDRs lies in its automatic character. Unlike the existing IMF drawing rights, SDRs are not created by countries’ contributions of gold and currency to the Fund and once drawn they do not have to be paid back to the Fund. The novelty of SDRs lies in that they would not be treated as borrowings as is the case with the ordinary drawing rights and existing claims on the IMF.
The SDRs could be used as gold in as much as they would be the ultimate source for purchasing other currencies. The international money created in the form of SDRs by the Fund constitutes official reserve assets for those who hold it. With the creation of the SDRs, the Fund has clearly served in a direct manner as a central banker to the monetary authorities of member-countries.
Its great merit lies in that reserve creation in the Fund has become a deliberate process under international control—the decisions to create new reserves of SDRs are made on the basis of careful calculation and judgment as to the need for reserves by the world community and on the basis of a recognition that world payments equilibrium requires. Hence, SDRs are, as such, quite different from ordinary drawing rights.
Mr. P.P. Schweitzer, the Managing Director of the IMF, strongly defended and praised the Fund’s SDRs as an effective supplement to traditional reserve assets. He described the creation of SDRs as a major advance in the evolution of international monetary system.
President of the USA welcomed the scheme as a great step forward and appealed to world monetary authorities to look beyond gold with the help of SDRs. Richard Cooper, Professor of Economics at the Yale University, called the scheme of SDRs a progressive and potentially important step which will ultimately replace gold in the world monetary system. By agreeing to the scheme of creating SDRs in September 1967, the Finance
Ministers of the free world took the first and momentous step to solve the problem of international liquidity. The significance of the scheme lies in the fact that for the first time as a result of deliberate international decisions, the total stock of reserves and its rate of growth are determined, rather than allowed to be determined solely by the availability of gold and the accumulation of balances in reserve currencies. SDRs—the paper gold—will be international money which will keep the world trade and economy moving.
It will be backed by nothing more than a fact that nations will accept it in payments for world trade and it will exist only on the Fund’s books (like bank credit deposits) and will change hands only on ledger-sheets. These SDRs, created as these were, by a stroke of the pen will essentially be entries in the book of the Fund. Simplicity, flexibility, unconditional character of liquidity designation and reconstitution provisions are an integral part of the SDR Scheme and constitute its main merits.
The decision to create SDR has given the IMF the authority to create monetary reserves systematically so as to assure an adequate volume and growth of international reserves without having to rely on gold or the balance of payments deficits of the reserve currency countries. It also enabled the participating member-countries of the IMF to add to their reserves without any net export of real resources or repayment.
In the light of these characteristics the SDR was envisaged to pay a prominent role as an international reserve asset and the future creation of monetary reserves would be largely through SDR allocations. Moreover, the replacement of the internationally held key-currency balances by SDR would not only reduce the reserve currency role of the dollar but also bring to an end the privilege of the United States to run huge balance of payments deficits with its own currency (seigniorage benefits).
But SDR scheme has not been welcomed as an unmixed blessing and, therefore, has been subjected to the following critical comments:
1. It is said by Paul Einzig that it is no safeguard against a major emergency. The fact that the SDRs would be released in five equal annual installments shows that it is not an emergency measure which wills immediately place or release large resources during emergency to meet the problem. The facilities are meant for financing routine expansion of world trade. SDRs can be used so far, largely to meet the balance of payments difficulties.
2. The plan is denounced on the ground that it has an inflationary bias. The system of SDRs is likely to operate as a built-in-inflator. It is bound to over stimulate expansion leading to higher prices. The developed countries have argued that one of the causes of the global inflation in the 1970s has been an unwarranted increase in the present size of global reserves. But this limitation is not peculiar to SDRs, any scheme of increasing international liquidity will have an inflationary potential, which has to be avoided by judicious application of the scheme.
3. It is argued that though the SDRs are automatic yet they are not the same as owned reserves. Many countries are still not prepared to regard second line reserves in an international institution as equivalent to till money. But, after all, the various types of facilities that go to add to international liquidity cannot be in the nature of owned reserves.
4. Doubts have also been expressed about the designation provision, on which the scheme of SDRs depends. The Fund has the directing role in designation so that participating countries can get currencies in exchange for their SDRs from member-countries which are in surplus. The Fund expects members generally not to swap SDRs with currencies and/or gold and vice-versa without designation.
It is said that in the absence of designation by the Fund the scheme may not work at all. SDRs become effective media if each participant accepts the obligation that it will part with its currency to a maximum of thrice its quota of SDRs. The Fund, as such, has to be assured of designation, without which members may have to borrow amongst themselves informally.
5. Distribution of SDRs will be based on quotas, which is, something quite irrational. Quotas are themselves out of alignment with the economic position of different countries. The distribution of SDRs on the basis of quotas is, therefore, inequitable and arbitrary because they ignore the needs of the countries on which distribution of SDRs should be based.
6. Again, the freedom of opting in and opting out during the basic period makes the possibility of empty periods more real and as such SDRs cannot be accumulated continuously like gold. This brings in an element of uncertainty and makes the whole scheme of limited value. Moreover, it is said that it provides no solution to the real problem. It does not get to the root of the problem and provides only marginal help to cover the problem of deficits.
7. Mr. Schweitzer, Managing Director of IMF, did admit that the problem of veto presented a snag in the scheme. The resistance of any country or a group of countries holding fractionally more than 17 per cent of the voting rights in the IMF would be fatal to such a proposal. This was the chief reason why the scheme got a mixed reception in USA.
8. It is said that deliberate creation of reserves in the form of SDRs by the conscious decisions of member-countries is one of the great merits of the scheme—but it is also a great demerit because there is the problem of correct interpretation of global needs. How global needs are to be defined, understood and what factors are to be taken into account—all present practical difficulties. Deciding the right quantity of reserves to be created at a time is not an easy job.
9. Experts like Milton Friedman, Bernstein, Triffin felt that activation of SDRs without greater flexibility in the exchange rates would be a great mistake. According to these experts what the international monetary system needs is not a greater capacity to postpone adjustment— which the most that SDRs or any other reserves can provide—but a better adjustment mechanism.
10. To some critics, the entire scheme of SDRs appears to be a rescue operation for the ailing dollar. The entire scheme is a clever attempt to rehabilitate the dollar by means of collective international action because the value of the SDR is prescribed to be equal to the present official gold value of the dollar. (This position had changed in 1976). The whole scheme is in favour of USA and is disadvantageous to the poor economies.
11. It has also been remarked that the rate of interest on SDRs is very low, being around 1.5 per cent. It will encourage deficit countries to use their SDRs in preference to other reserves to finance their deficits. On the other hand, the surplus countries will be less eager to accumulate the SDRs on account of the low rate of interest on them.
SDRs and Developing Economies:
The greatest criticism, however, of the SDR scheme has come from developing economies because SDRs do not provide for a specific link between reserve creation and development assistance in underdeveloped countries. Besides, their creation and distribution are arbitrary and unjust from the viewpoint of developing economies.
They also complain of small share in any allocation of SDRs as against developed countries. The share of developing countries is not likely to be more than 28 per cent of the aggregate issue. Prof. Triffin, the US Economist, also denounced the scheme of paper gold on this ground. He said, “It is morally repugnant to assign the lion’s share of the SDRs (about 72 per cent) to the 25 richest and most developed countries of the world.”
Apart from the share in the Fund quotas, the share of the developing countries in the direct distribution of the SDRs, or the paper gold, as it is called, which is intended to replace gold in the international monetary system, is quite negligible, the major share in each fresh distribution going to the big industrialized countries; thus defeating in no small measure the main objective of transferring real resources to the poorer countries.
Of nearly 9.0 billion SDRs held by member-countries in 1976 and early 1977, the USA alone held nearly 2 billion SDRs or more than a fifth. Thus, the distribution of IMF facilities, to increase international liquidity amongst its members, either in the way of normal entitlements under the quota system or in the form of direct allocation of SDRs, has not been designed to bridge the gap between the rich and the poor countries, who remain far apart from each other as before, if not worse off.
It is true that the scheme of SDRs in its present form and as applicable to developing economies has a good number of limitations, which go to make this scheme, as such for them, of limited value. Even then, these poor economies are not justified in denouncing the scheme on the grounds that the facilities available under it are inadequate or unjust or that advantages are uncertain or that they face the possibility of additional inflation or that there is no link between development finance and international liquidity.
Special drawing rights are also of great use to developing economies firstly, by enabling them to maintain somewhat more adequate reserves; secondly, by enabling them to maintain their economies on an even keel thereby saving them from abrupt shocks. Thirdly, by providing them potential benefits from the maintenance of adequate reserves, especially in industrial countries which take the bulk of their exports and provide them with capital.
Fourthly, if the less developed countries so desire, they can together as participants veto proposals for SDRs allocations over some basic periods. Developing countries also gain indirectly inasmuch as their currencies get strengthened, thereby promoting international trade. The developing countries are likely to gain more in the form of aid as well as trade from this scheme. There is a definite implied link (though not direct link) between the creation of international liquidity through SDRs and the pursuit of more liberal aid and trade practices on the part of rich nations.
Special Drawing Rights: The Present Position 1988:
It would be proper to review the importance and the present position of SDRs once again in terms of its characteristics as money beyond 1988 onwards:
As a Medium of Exchange:
As a medium of exchange SDRs had an important but only a limited role to play to start with. It was due to the constraints that the Fund had put on the use of SDR accounts held with it. If was also due to the fact that the use of SDR—denominated assets and liabilities by institutions other than the Fund and the monetary authorities that deal with the Fund had so far developed in a limited way.
Still, participants use SDRs to obtain foreign exchange from other participants designated by the Fund; to settle obligations to repurchase balances of a participants’ currency from or to pay charges to the Fund’s General Account; to obtain balances of the user’s own currency held by the participants.
After the Jamaica Plan of (March 1976) the Second Amendment of Articles of Agreement of IMF were put into effect in 1978 laying down much wider scope of use of SDRs. All the 150 or more members of the Fund (in 1988) were participants in the SDRs Department, and all except 5, which joined the Fund after January 1, 1981 had received SDRs in allocations.
These amendments allowed participants:
(i) To use their SDRs to obtain currency in transactions by agreement with other participants (bilateral transactions) without specific authorization by the Fund ;
(ii) Allowed operations in which participants may use SDRs by agreement without exchanging them directly for currency ;
(iii) To use SDRs in interest payments and repayment of principal ;
(iv) To make loans of SDRs at interest rates and maturities agreed between the parties ;
(v) To use SDRs to settle financial obligations (other than to make donations).
In 1980 decisions were taken to allow the use of SDRs in sweep arrangements and forward operations against currency or another monetary asset (other than gold), and to use them in donations. Fund members apart from continuing to make repurchases of the Fund’s holdings of their currency in SDRs were now required to pay all charges due to the General Resources.
Account in SDRs under the Seventh General Review of Quotas, participants was required to pay 25 per cent of their increased quota subscriptions in SDRs. New members can use SDRs in part payment of their quota subscriptions. Besides, attempts were made (and continue to be made) to enlarge the volume of SDR denominated financing in the private markets, the number of official institutions that may deal in SDRs is also increasing.
The Fund is authorized under the Articles to prescribe as holders of SDRs non-member countries (like members that are non-participants in the SDRs Department, institutions that perform functions of Central Bank for more than one member and other official entities).
These are called Prescribed Holders or SDRs. Institutions that are prescribed by the Fund as holders of SDRs may use SDRs and engage in any of the operationsmentioned above but they cannot receive SDRs in allocations, to use the designation mechanism or to deal in SDRs with the Fund’s General Account, except when they are lenders to the Fund. Thus, a number of such official institutions are engaged in transactions and operations, acquire, hold and use SDRs as a medium of exchange. There has been no addition in the list of the institutions that to date are the prescribed holders of SDRs.
As a Store of Value:
As a store of value, the performance of SDR rests on the performance of its constituent currencies. If the constituent currencies lose their purchasing power at high or uneven rates, the SDR will be less attractive as a store of value than the superior performers among national currencies.
Moreover, the rate of interest on SDR is not very high as to induce its holding for speculative purposes. It is not even possible, for example, to hold it or to use SDR to change composition of reserves, if the need arises.
The SDRs are created with good deal of caution only to meet limited objectives like the balance of payments difficulties, etc., and as such their supply is hardly enough even to meet these limited objectives. Therefore, all this did not make it are attractive asset to hold for its holders as some other reserve assets because SDR is not a tangible asset like currency.
Despite these limitations with its effective yield comparable to the yield on a multi-reserve currency holding, it is considered an attractive asset for a monetary authority or central bank to hold as part of its foreign reserves.
As a Standard Reserve:
The second amendment to Fund’s Articles of Agreement became effective from April 1, 1978. As such, the international monetary system came to be rightly described as ‘SDR Standard’ as against gold standard or gold exchange standard or the dollar standard of Bretton Woods System:
(i) SDR as the Fund’s unit of account came to be increasingly used in international transactions. Participants came to have full freedom to enter into transactions in SDRs without being subject to some of the vigorous requirements of the Articles;
(ii) The possible uses of SDRs operations and transactions had been expanded. The Fund became empowered to permit more public (though not non-official) entities to hold SDRs. The amendment of the Articles in 1978 of the Fund at Jamaica enhanced the process of establishing the SDR as an instrument of international currency having general acceptability amongst nations and members were required to collaborate with the Fund in pursuit of the objective of making the SDR the principal reserve asset of international monetary system;
(iii) Its link with gold had been given up. Gold war is no more in the picture and stood dethroned;
(iv) In order to make SDR an effective international asset, there would be both immediate changes in the characteristics of the assets and possibilities for further developments. Immediately, there was for greater freedom for members to engage in transactions by agreement in SDRs, and much wider possibilities for transfers of SDRs to and from the Fund itself. Official entities would hold more SDRs and engage in broader range of transactions than before 1978;
(v) Provisions had also been made in the above plan for the Fund to permit new forms of operations in SDRs, for example, loans or grants, thus, helping to bring the characteristics of SDR closer to those of traditional reserve assets.
Two factors had been mainly responsible for the enhanced role of SDRs and making it standard reserves after the second amendment to the Articles of the Fund in 1978, these were (a) the reduction of the role of gold as the standard of reference for the value of currencies, and (b) the large and often violent fluctuations in currency values which had taken place under floating exchange rates. The total amount of SDR remained at SDR 21.4 billion; as there have been no allocations since January 1981. The volume of activity in the SDR declined in 1984-85 to SDR 15.7 billion from record level of SDR 22.7 billion in 1983-84.’
In actual practice, however, SDR had neither become the principal reserve asset in the world monetary system nor the major source of the growth of international reserves. The foreign exchange component (largely US dollar) of the international reserves has continued to rise and since their inception SDR has amounted to less than 6 per cent of the non-gold reserves of the world.
The reasons for this passive role of SDR seem to be a number of major changes that occurred in the international monetary system particularly during the early 1970s. These include the U.S. decision to terminate the gold convertibility of the dollar in 1971; the international liquidity explosion of 1970-72; the collapse of the Bretton Woods fixed parities and the transition to widespread floating in 1973; and world inflation stemming from the huge rise in oil prices during 1973-74.
The reluctance of reserve currency countries to agree to new allocations of SDRs and the emergence of the multi-currency reserve system also prevented SDRs from playing a significant role in the international monetary system as an international reserve asset.
As a Unit of Account:
SDR has become the unit of account for all transactions and operations of the IMF. A good many international and regional organisations, which are looking for a hedge against excessive exchange rate fluctuations, have started to use SDR as a unit of account.
SDR is also used in international financial markets to denominate a wide range of private financial instruments and obligations such as commercial bank credits, syndicated loans, fixed and floating rate certificates of deposit and Eurobonds (so-called private SDRs). The role of private SDR is still very small and actually there was a decline in its use as no new security issues or bank credits were denominated in SDR during 1986 and 1987.
As a matter of fact, as a unit of account it is widely used now, and to date its major and most popular use has been only as a unit of account. The Fund’s accounts are kept exclusively in SDRs. Some 14 to 16 international organisations use the SDR as their unit of account. The SDR is also used as a unit of account (standard of value) in a significant number of international conventions.
By July 1986, 12 members of the Fund had pegged their currencies and exchange rates to the SDR. The use of the SDR as a unit of account got further impetus in 1981 on account of the simplification of the SDR valuation basket. However, the market in SDR—denominated assets is a small segment of the total private market.
The increasing use of the SDR as a unit of account (or as the basis for a unit of account) is explained, in part, by the fact that the value of the SDR tends to be more stable than that of any single currency in the basket, since it is weighted average of the exchange rates of the five major currencies in which the prices of goods and services in international trade are denominated. Currency deposits denominated in SDRs are accepted by the BIS and more than 30 commercial banks in financial centres throughout the world.
As a Currency Peg:
Some of the Fund’s member countries have decided to peg their currencies to SDR Unit. SDR Standard is establishing itself in a variety of ways: as a currency peg, as a unit of account, for bond issues and as a definition of obligations in many international agreements. By September 1987, 12 of the Fund’s member countries had pegged their currencies to SDR. The value of the member’s currency under such arrangements is first fixed in terms of SDR and then set in terms of other currencies by reference to SDR value of the other currencies as published by the Fund.
By using SDR as a currency peg, these countries insulate their economies to a certain degree from shocks emanating from exchange rate variations among the major countries. It seems that for less developed countries with a diversified import structure, the most appropriate exchange rate policy would be to peg in terms of a common basket of foreign currencies, in particular the SDR as its value tends to be more stable than that of any individual currency.
SDR—As a Private Asset—Its Wider Use Likely?
Parallel to the development of the Fund’s or official SDR, international organizations, borrowers, and investors looking for a hedge against the current combination of uncertainty interest and exchange rate developments have started using the same unit of account, creating the ‘commercial’ or ‘private’ use of SDR. The value of private SDR is by and large determined on the basis of the same basket of currencies as the official one.
However, private value and use of SDRs do take into consideration the conventions of market place and are not constrained by the rules governing the uses of official SDRs. The main impetus of commercial or private use of SDR came from the simplification of official SDR basket in 1981 which made it more attractive asset to international financial markets.
As a result, it is now used to denominate a wide range of private financial instruments and obligations, such as commercial bank current accounts and deposits, syndicated loans, fixed and floating rate certificates of deposit, floating rate notes and Eurobonds. But the use of SDR in private markets has developed rather slowly. In 1981, no doubt there was burst of activity in the use of private SDR instruments but it was not prolonged or widespread enough so as to create a self-sustained vibrant market for private SDR.
The reasons being the lack of familiarity with the use of SDR due to investor’s natural aversion for complexity and weights attributed to its constituent currencies in the basket as they did not reduce exchange rate risk adequately; the Fund did not actively contribute to the establishment of private market for SDR denominated instruments, etc.
Usually, the private interest in the SDR is strongest when the US, dollar is weak. A few transactions are then arranged, but as soon as the US dollar improves the volume tends to ebb. This was experienced in 1987 and early 1988 when the value of dollar fell. Preferably, however, the SDR should be viewed as an all-weather instrument and not as a short-run speculative alternative to currencies.
The viability to the SDR rests on the proposition that it is more stable than individual currencies and that it helps give a means of exchange stability to those whose business is either in SDRs or who are exposed to exchange risks in several currencies in proportions approximately matching the composition of the SDR. For the time being, the private market for SDRs is still small but more than a dozen commercial banks are presently 1987-88 actively accepting short-term currency deposits indexed in SDRs and many pore are interested in developing this business.
The banks accepting SDR deposits usually will try to cover themselves, for example, in the forward markets or make loans in the individual currencies; which comprise the SDR. Less frequently, they extend SDR-denominated loans. The private financial market in SDR-denominated paper is a somewhat specialized market—this is reflected in the relatively low volume of notes traded, in the predominance of short maturities, and in the fact that little if any re-depositing seems to take place.
There are, however, three potential sources of future growth:
(1) The rising number of official institutions based on the SDR and engaged in the private markets ;
(2) The trend toward diversification of central bank reserves, including a possible desire of central banks to cover open SDR-denominated positions resulting from their indebtedness to the Fund ; and
(3) The deficit countries, which are familiar with the SDR and may be willing to take up medium-term banking credit indexed in SDRs to spread their currency risk.
As regards the Fund, no plans exist it the moment to issue SDR-denominated notes to the market, although the legal possibility exists for the Fund to do so with the consent of the members whose currencies it would use as a vehicle.
As a trustee of the Trust Fund, the Fund could also, if it so wishes, place SDR deposits with commercial banks. So far, however, all deposits have been placed with the BIS. The private SDR could be revived if international market operators anticipate that the considerable fluctuations and uncertainties in interest and exchange rates of recent years are (1987- 88) likely to continue and are to be and should be hedged.
Both the Fund and its member central banks could play an important role in making an infant currency an adult by broadening the scope of private sector use of SDR. Specifically Fund could enhance its role by being fully committed to support the private use of SDRs, by augmenting its resources through borrowing from private market, by encouraging more member-countries that peg their currencies to do so to the SDR and by creating or encouraging a settlement system for international payments in SDRs.
SDRs—Future Safety Net:
The main purpose of creating the SDR was to make the supply of reserves less dependent on the official settlement balances of US and to provide an alternative to counteract reserve shortages. It was decided under the First Amendment of the Articles of IMF to allocate SDRs “to meet the need as and when it arises for a supplement to existing reserve assets.”
The second Amendment of the Articles of Agreement of IMF in 1976 at Jamaica and implemented in 1978 exhorted the members to “make SDRs the principal reserve asset in the international monetary system”. But despite these efforts SDR could not assume a major role (as anticipated) in the system.
In fact, its share in the total foreign exchange reserves had actually declined during the last decade. The use of SDR as a unit of account in private transactions remained limited and the market for SDR denominated assets and liabilities did not expand much. The limited success concerning SDR as an international asset may be due to its, features and restricted usability.
Developments in the international—especially the expansion of international financial markets provided a flexible and efficient source of reserves to many countries and accounted for declining interest in SDRs. Moreover, the emerging trends in multi-currency reserve system have reduced dependence on single currency in international settlements and reserve holdings. All this affected the objective of placing the SDR at the centre of the system as the main reserve asset.
Nevertheless, it is believed that the instrument of SDR still have a useful role to play in meeting the long-term global needs for supplementing reserves in a system largely based on borrowed reserves’. As such, the availability of SDR as a ‘safety net’ for future contingencies must be considered.
There is no agreement on the question whether the present situation calls for new allocations of SDRs. The developed countries led by USA argue that there is at present no clear evidence of a long- term global need to supplement international reserved, given the present state of total reserves and lending from international markets. They think that international financial markets and official channels provide adequate means of meeting the global demand for reserves and regular SDR allocations would lead to excessive liquidity creation apart from inflation.
The developing and underdeveloped countries, on the other hand, stress for new and regular allocations of SDRs. They argue that the severe strains that have been built up in the system over the last decade or so are reflected in the decline of reserves in relation to imports and foreign debt, the lopsided distribution of reserves and the rise of barter trade. Apart from short-term considerations relating to the state of liquidity, a resumption of SDR allocations is justified by long-term systematic considerations also.
Long-term growth of trade must be supported by an expansion of international reserves—SDRs, therefore, should be rejected into the system in accordance with a ‘steady’ quantitative rule so designed that their relative role in official reserves would expand gradually over time. It is rather sad that developed countries should take such a technical and narrow view that there is no ‘global need’ and, therefore, no need to create SDRs. Affluent countries argue that the gravity of debt problems calls more for adjustment policies and conditional financing than the general creation of SDRs.
The arguments advanced by developed countries led by USA miss basic facts: First, reserve assets in the shape of SDRs are owned reserves and as such are qualitatively different from reserves acquired through international commercial borrowings; Second, the terms and conditions at which commercially borrowed reserves are supplied, reflect more than the borrowers’ own policies and performance on which hinges their credit-worthiness—apart from the fact that such borrowings entail heavy costs.
An allocation of SDRs on regular basis will enable these (developing) countries to have at their command additional liquidity at no cost. Since interest is payable on the net use of SDRs. The fact cannot be ignored that the rich countries continue to approach the issue of a fresh and regular allocation of SDRs in terms of minimum role it can play—to tide over the problem of debt burden— and not in terms of resources to those who need them most for development.
During the period since the first allocation of SDRs, the international monetary system has undergone a number of structural changes. The first of these was the suspension of the convertibility of official US dollar balances into gold in August 1971. Second was the breakdown of the system of fixed exchange rates and the advent of greater exchange rate flexibility.
Third was the expansion and integration of international credit markets, particularly those involving bank assets and liabilities. And fourth was the growth in the importance of currencies other than the US dollar in official reserves. According to the authors of the IMF Occasional Paper, “these structural changes significantly altered the mechanisms through which reserves are provided and have had far-reaching consequences for the international monetary system as a whole.”
They point out that since the first allocation of SDRs, increasing attention has been paid to the potential contribution of the SDR to the stability of the international monetary system. The argument has been made that excessive borrowing could be avoided or reduced if reserves were regularly supplied through different channels, particularly by allocating SDRs.
In addition, they observe, it has been suggested that the SDR might play a role in controlling the amount of international liquidity. It is a pity that in spite of the stated objective of making SDR the principal reserves asset of the international monetary system, the IMF could not so far achieve consensus on the contribution of SDR to the creation and distribution of international reserves.
Consequently, SDR’s role in the system has been minimal and the reserve currencies, particularly the US dollar, continue to dominate the supply of international reserves. Nevertheless, SDR remains the only reserve asset through which the IMF can effectively regulate the amount and distribution of international reserves. Every effort should, therefore, be made to strengthen the role of SDR as a component of international reserves as well as a unit of account.
SDRs and Substitution Account:
Unlike gold which became an international currency because of its intrinsic value or the domestic currencies like sterling or the dollar that became international currencies because of their strength, convenience and general acceptability, SDRs, came into existence as international money by a decision of the international community setting up a system of right, duties and obligations relating to the holding and use of the new reserve asset.
Its most distinguished feature being that these rights are created deliberately from time to time, by agreement of the international community in agreed quantities and distributed amongst the member-countries on agreed principles. Already there is a demand from certain countries to create more SDRs beyond 1988 but there are differences on the quantum or magnitude of additional creation for which the discussions go on as is evident by the Fund meetings held at different places up to 1988.
Despite differences the general consensus amongst countries was that more SDRs should be created beyond 1988 onwards for the problems facing the inter-relationships governing resource flows between the third world and the rest of the world are dispassionately analyzed— taking into account the massive terms of trade loss that the third world has suffered—the creation of SDRs and their fair distribution cannot but be taken up urgently.
It is rather unfortunate that the issue of additional creation of SDRs beyond 1988 tends to be viewed basically in terms of the size of conditional liquidity that the IMF should extend. Surprisingly, the Managing Director of IMF and Deputes reported that they had not been able to make a proposal for additional creation of SDRs because the broad support’ required by the Articles of IMF was lacking.
What was at one time being proposed amounted to a radical change both in the method of its creation and the manner of its use. The proposal was for the creation of SDRs in exchange for the excess dollar holdings of various countries to be held by the International Monetary Fund in Substitution Account. The idea underlying the Substitution Account was to provide SDR against surplus dollars invested and thus make a cushion against short-term movements of a single currency.
This step was also designed to enhance the role of SDR, under which swapping of dollars for SDRs is intended. It was also proposed that the SDRs thus created would be available for holding by the private sector so that a secondary market could develop for it over a period of time. To make them an attractive asset to hold, it was proposed that they should carry higher rates of interest than at present. As compared with dollar-dominated assets, SDRs would have the advantage of lower exchange risk.
Being equal in value to a basket of five major currencies, fluctuations in the value of SDRs would tend to be smaller than those of any individual currency. Private holding of SDRs would as a result be both permitted and encouraged. They would provide to both official institutions and private bodies a viable alternative to the holding of dollar-dominated assets, whose sheer volume in international markets has become unbearably large.
Who will bear the burden of the Substitution Account’s exchange risk is another question altogether. This risk arises from the discrepancy that could develop over a period of time between the value of the Substitution Account’s dollar holdings on the one hand and of its SDR liabilities on the other.
Since the main objective of the proposed Substitution Account is to deal with the problem of the dollar “overhang”—primarily a problem facing the United States—it is being suggested that the risk should be borne by the United States.
That country is, however, unwilling to do this and would like the burden to be borne by the rest of the world, particularly the other major industrial countries, until this question is resolved. The Establishment of Substitution Account has been postponed for time being to resolve this problem. It is hoped USA will agree to bear the risk, failing which, SDRs will get a setback and gold will gain importance which stands dethroned.
Thus, in order to enhance SDRs role in the international monetary system three conditions are essential:
First, allocations should be made at regular intervals so that SDR constitutes a large proportion of the total international reserves.
Second, the use of SDR in transactions outside the official circles should be enhanced.
Third, the future allocations of SDR should be determined by countries’ need for additional reserves rather than their IMF quotas. This would give less developed countries a larger share of SDR allocations to help replenish their international reserve assets.