China Society for Finance and Banking, Reinventing Bretton Woods Committee
Conference-70 years after Bretton Woods: The international monetary system, Hangzhou 17-18 May 2014
Ousmène Jacques Mandeng, Global Institutional Relations Group, Prudential Investment Management
Ladies and Gentlemen,
My remarks will focus on the SDR basket to reflect on the role it plays today and more importantly could play. The internationalisation of currencies, capital account opening and the SDR basket are naturally linked to one another. Capital account opening constitutes to some extent a necessary condition for currency internationalisation and major international currencies should normally be eligible as constituents of the SDR basket. Yet, one of the most salient features of the international economy is the fact that very few currencies have become truly international despite important and widespread capital account openings. This is assumed here to be due largely to still limited capacities of many currencies to serve readily in international transactions but also to the absence of a supportive framework conducive to greater international currency diversification. As such the international monetary system has seen too little innovation against the considerable changes that are occurring in the international economy.
The IMF’s SDR basket has remained very narrow. This rests on the fact that the SDR has tried though but mostly unsuccessfully to rival conventional reserve assets. Instead, the SDR could lead international currency diversification by aiming to complement rather than substitute current reserve assets. It should not attempt to become a major reserve asset let alone a global currency. This would be a more limited but likely more effective role. In a world of highly homogenous and undiversified reserves, this matters. Anecdotal evidence strongly suggests that central banks seek greater diversification in international reserves. The SDR basket by remaining too restrictive risks missing an important opportunity to facilitate currency internationalisation and hereby lay the foundation for addressing key deficiencies of the international monetary system. Criticisms about the SDR have of course been expressed by many including the IMF but few to my best knowledge recommended to reduce and change its focus entirely.1
The international monetary system, the rules and regulations guiding international liquidity management to support orderly exchange markets vital for a balanced expansion of international trade and finance, has not changed much since the establishment of the IMF in 1945. It has long been seen with concern that the system continues to rely on a narrow set of national currencies to manage international liquidity and as such is subject to the vicitudes of the national policies of the main currency issuing countries. The Federal Reserve is a national entity and has no mandate to accommodate international liquidity needs. This despite the fact that the dollar is also the main international currency. The four currencies or their equivalents that make the SDR basket today—the dollar, euro, yen and sterling—represented 100 percent of foreign exchange reserves in 1950 and 94 percent in 2013 (Figure). The international economy has yet to address the international monetary consequences of globalisation.
The Special Drawing Right (SDR) is an international reserve asset issued by the IMF. International reserve assets are external financial assets or currencies, e.g. U.S. treasury notes or dollars to intervene in foreign exchange markets normally held by central banks. The SDR constitutes potentially a claim on freely usable currencies, currencies that can readily be used in international financial transactions. This allows the SDR de facto to be a substitute for the dollar. The SDR is a purely official asset and can only be held and used by countries participating in the IMF SDR Department, the IMF and some designated official entities and is used almost exclusively in transactions with the IMF. Countries are obligated to exchange SDRs for freely usable currencies but only up to twice their cumulative allocations of SDRs. The value of the SDR is determined by the value of the SDR basket.
The SDR took off in 1970 as a major financial innovation.2 The SDR was intended to provide a serious alternative to the dollar and gold at a time when there was considerable concern about inadequate reserve growth to accommodate increasing international liquidity needs thereby hampering the orderly expansion of international trade and finance.3 So much, that the IMF wanted the SDR to become the principal reserve asset.4 The underlying idea was that international liquidity should not be dependent on the possibility to accumulate international reserves. Circumstances changed and to date only about US$316 billion of SDRs are outstanding compared with about US$12,000 billion of foreign exchange reserves.
The limited SDR allocations rest largely on the assumption that there is no shortage of international liquidity. Hence key IMF member countries opposed subsequent allocations. Only in 2009 after no allocations during the 1980s and 1990s, when amid the global economic and financial crisis, the G20 decided to support a renewed SDR issuance, did the amount of SDRs increase to something a bit more meaningful. The SDR issuance history was plagued by a rift between advanced economies arguing against more issuance on the basis of shortage and mostly emerging markets that favoured issuance on the basis of the SDR’s ability to improve the quality of the international monetary system.5
The SDR was originally valued in gold. In 1974 with the collapse of the Bretton Woods system it was redefined in terms of a weighted basket of currencies. The basket originally contained 16 currencies selected on the basis of the issuing countries’ shares in international trade. The basket was subsequently reduced to 5 currencies in 1981 largely on the premise that several of the 16 currencies were not used widely in international financial markets. There was considerable controversy about reducing the number of currencies amid opposing views as to the role of the SDR. The adoption of a 5-currency basket, subsequently reduced to 4 currencies with the introduction of the euro, followed mostly market-based criteria to facilitate valuation of the SDR (Table).6 The valuation guidelines of the SDR have rested on long-standing principles aimed to enhance the attractiveness of the SDR as a reserve asset. In 2000, an IMF decision formalised what has long been practice namely to include only currencies in the SDR basket that are freely usable.7 Other principles guiding SDR valuation include that the currency weight should reflect their relative importance in the world’s trading and financial systems and that any revision in the valuation method should only occur as a result of major changes in the roles of currencies in the world economy.8
The possible limitations of the narrow SDR basket have been of course recognised by the IMF. However, in 2010, an IMF Board paper affirmed that the inclusion criteria for the SDR basket should be “tailored to preserve the reserve asset status of the SDR and one that could help promote a smooth evolution of the [international monetary system].”9 The assumption that the SDR has to preserve its reserve asset status is considered here to represent the SDR’s biggest drawback. The SDR as a mere substitute for freely usable currencies that is readily replicable in the market adds very little or no value net of rebalancing costs.10 The narrow definition of a reserve asset that has guided SDR valuations is too constrained and distract from alternative possible motivations for holding SDRs. Efforts to revise inclusion criteria by broadening existing criteria, e.g. foreign exchange transaction volumes, debt securities outstanding, etc, merely entrench most ordinary criteria for reserve assets. For most central banks SDRs do not constitute needed reserves.
The SDR could serve to allow central banks to gain exposure to currencies that are not freely usable or easily accessible. This would make the SDR an asset with properties that are not readily replicable and offer some diversification to dominant reserve allocation patterns. SDRs could be made of a larger number of currencies where selection could be guided by economic metrics and countries’ stated desire to pursue internationalisation of their national currencies. Technological advances and in many instances considerable sophistication of central bank reserve management departments should allow for much greater complexity of SDRs than previously thought feasible. The underlying assumption is that a broader SDR basket would be held as an investment asset principally to increase reserve diversification and not be hedged.
The possible catalytical role of the SDR rests on the presumption here that the use of international currencies is in large part endogenous to central banks’ reserve allocation behaviour. The U.S. treasury market is deep and liquid also because central banks hold so many treasury securities. International currencies are not only a market phenomenon. Historic observations seem to affirm the notion that currencies are widely used internationally if supported by an adequate institutional framework, e.g. sterling in the colonial sterling zone, the dollar in the Bretton Woods system, the mark in the European monetary system.
The SDR needs a new and more focused approach. It has tried in vain to become a leading reserve asset. Rather than being a substitute for existing international currencies the SDR should complement existing reserve holdings and serve to promote new international currencies as a framework for change.11 As such the SDR would address the lack of needed innovation in the international monetary system. A broader SDR basket would signal a broadening of currencies held by central banks thus eventually encouraging central banks to hold a greater number of currencies outright. The SDR was established with different concerns in mind that proved no longer relevant already shortly after its launch. The shortage concern is outdated. The SDR debate should shift now towards those countries that in the past supported the view that the SDR should be seen to improve the quality of the international monetary system and regain its earlier aim for inclusiveness. This would support the internationalisation of currencies and orderly capital account opening. Here seems to lay the only meaningful mission for the SDR.
1People’s Bank of China Governor Zhou Xiaochuan has become a leading voice for a broader SDR role and wider basket with his address “Reform of the International Monetary System” of March 2009. Most critics recommend strengthening the role of the SDR as a reserve asset or even a global currency, see e.g. Fred Bergsten, The dollar and the deficits, Foreign Affairs, December 2009; Joseph Stiglitz, The best alternative to a new global currency,” Financial Times 31 March 2011.
2 The SDR was agreed in 1967 at the Rio de Janeiro IMF Meetings and SDRs were first allocated by the IMF in 1970.
3 Issuance of the SDR was in large part motivated by the so-called Triffin dilemma, see e.g. Ousmène Mandeng, “Reserve currencies and solving the new Triffin dilemma,” Central Banking Journal, February 2009.
4 The decision was adopted in 1978 with the second amendment to the IMF Articles of Agreement, Article VIII Section 7: “Each member [country] undertakes to collaborate with the Fund and with other members in order to ensure that the policies of the member with respect to reserve assets shall be consistent with the objectives of promoting better international surveillance of international liquidity and making the special drawing right the principal reserve asset in the international monetary system.”
5 See James Boughton, Silent revolution, the International Monetary Fund 1979-1989, IMF October 2001.
6 See Boughton 2001. Boughton noted a main motivation for reducing the basket to 5 currencies was also due to the fact that the interest rate on the SDR was calculated on the basis of the 5 main currencies.
7 SDR valuation basket—Revised guidelines for calculation of currency amounts, Decision 12281, 11 October 2000, IMF Selected Decisions, 36th issue, Washington, D.C., 31 December 2011.
8 See IMF 2011 and IMF press release no 00/55, IMF completes review of SDR valuation, 12 October 2000.
9 IMF, Criteria for broadening the SDR currency basket, 23 September 2011.
10 The SDR does of course constitute a net addition to international reserves and may for some countries represent an important portion of reserves.
11 To facilitate adoption of a different SDR, it would still have to qualify as a reserve asset to allow central banks to classify it as part of international reserves.