IMF’s Special Drawing Rights (SDRs), Explained

India has appealed to the International Monetary Fund (IMF) to create necessary infrastructure so that the developing world can better use its Special Drawing Rights (SDRs) and overcome the effects of the pandemic faster.

So what are these SDRs and how exactly could they emerge as a panacea for the world economy, if at all? Let’s find out.

Definition

To put it simply, SDR is a global reserve asset floated by the IMF which its member countries can freely exchange with each other without relying on any one particular currency or standard. Its value is determined by a basket of the world’s five leading currencies — the US Dollar (41.73%), the Euro (30.93%), the Yuan (10.92%), the Yen (8.33%) and the UK Pound (8.09%).

This means that instead of relying on the spot exchange values of any one currency, the weighted values of the top five are used for the SDR’s valuation to avoid over-dependence on one (quota is revised every five years).

The SDR value is also used to determine the interest rate (SDRi) charged by the IMF to member countries on their non-concessional borrowings.

Think of SDRs as a national savings account for the member nations which they can dip into at any time to firm up their spending capacity or fiscal deficiencies. The recipient countries can swap their SDRs with any of the above five fiat currencies. That’s why they are sometimes referred to as “paper gold”.

FYI: Rich countries can give their SDRs to low-income countries under the IMF’s designated framework if they are feeling generous.

So how are SDRs given to countries? Initially, they are allocated to member countries and eventually, the members are given two positions — “SDR holdings” and “SDR allocations”. Countries receive interest on their holdings and pay interest on their allocations position. Both the interest rates are calculated as per a country’s SDRi value.

In the beginning, the two positions (interest received and interest paid) cancel out each other. But as the country trades more SDRs for currencies, its holdings decrease and fall below allocations which means it now pays more interest than it receives.

The allocations are made over time, sometimes generally and sometimes in case of special circumstances. The amount of allocation for any single country is decided as per the proportion of its participation in the IMF capital, which is again related to the size of its economy.

History

The SDR (currency code=XDR) is a concept developed during the days of the Gold Standard. They were created by the IMF in 1969 with the intent to be held in foreign exchange reserves under the fixed exchange rates system back then. 1 XDR was equal to $1 or 0.888671 g of gold.

However, after the collapse of the Gold Standard, the role of SDRs was repurposed as an accounting unit for the IMF (since 1972). Even the IMF itself has bluntly admitted to the role of XDR being “insignificant”. But that doesn’t mean it’s obsolete.

At present, it is mostly used as an alternative to the US Dollar — the de-factoglobal reserve currency — when the Dollar is otherwise weak or unsuitable to be used for foreign exchange. In fact, some believe that it was the US policymakers’ fluctuating goal to prevent the shortfall in Dollar demand that gave birth to the SDRs and it was the “Dollar distrust” by other economies which made the SDRs survive this long by providing an alternative medium of exchange.

Why Create More SDRs Now?

One word. Liquidity.

In August 2021, the IMF distributed $650bn in SDRs, the biggest amount to-date. This dwarfs the previous allocation of $250bn done in the aftermath of the Global Financial Crisis of 2008.

It is a quick way to boost the financial firepower of poorer countries, in particular, which have been ravaged due to the pandemic. When their economies are on their last legs, the ability to borrow externally is severely impaired and not at all prudent if the goal is to avoid the burden of an unsustainable debt cycle.

What’s the Downside?

First and foremost. The unequal distribution. Although SDRs will prove most beneficial for the low-income countries, they wouldn’t receive the lion’s share of the pie due to the IMF “quota” system that is heavily skewed in favour of bigger and richer countries. The US, EU and the UK would receive at least half of the new liquidity.

What would help here is if these countries were overcome with the generosity to donate a portion of their SDRs or yield their quotas to the less-developed economies. But that is a question of policy, often mired with political considerations.

Despite the near-universal support for the issuance of new SDRs last year, it wasn’t instrumental until recently due to opposition from the Trump administration. US law also sets limits on the quantum of an SDR allocation that the Cabinet can accept without Congressional approval. It cannot exceed the US’s quota in the IMF, effectively capping the allocation to $680bn.

SDRs are also not a market-based asset. They are almost exclusively controlled by the IMF in all aspects including valuation, yield, holders etc., which, although makes them immune to market behaviour, also hamstrings their buoyancy and utility.

Then there is the possibility of giving unconditional cash injections to governments which have a proven track record of financial mismanagement and corruption. Consider the case of Lebanon, with $195.78m in SDRs, a country that has spiralled into chaos and poverty. Or Venezuela, for that matter, with $9.32m SDRs in its pocket has witnessed close to a 6,500% rise in consumer prices this year prompting large-scale migrations.

Hard-Currencies and Hard-Truths

Aside from the fact that SDRs are merely claims on hard-currency reserves, they also cannot be used in private markets which limits their utility greatly. It is essentially a reserve-pooling arrangement and a way to channel global liquidity from countries with greater liquidity to those with higher needs. So, low-income countries are better persuaded to accumulate other currencies directly as reserves.

One upside to SDR lies in their multi-currency composition that buffers against volatility. However, the premise of building an international reserve asset comprising a handful of “privileged” currencies is inherently elitist and inequitable. This is why the People’s Bank of China proposed “enlarging the basket of SDR currencies” in 2009, an idea that evidently hasn’t seen much traction since.

In any case, despite the SDR being a relic of an outdated Gold Standard era, the IMF has been prompt in steering its course towards modern economic realities. There have been talks to integrate the SDR mechanism with Bitcoin. There is also a marked improvement in their usage recently ($1.6bn worth hard-currency swaps have taken place this year already).

It remains to be seen if this so-called “supra-sovereign reserve currency” is profiled for better utility in the coming days or whether it translates into another IMF failure involving “special drawing wrongs”.

(Originally published October 21st 2021 in transfin.in)