The IMF and SDRs - complicating breakfast since 1969

The SDR is a lot like love. You think you know what it is, but can't really describe it. That said, I can certainly describe the SDR as not getting a lot of love, at least not from many IMF member countries. Nor from me in this blog entry. But let's see if I can at least try to describe the SDR a bit further.

A relic from a bygone era. The North Korea of reserves. The wrong solution to a problem that no longer exists. Always the bridesmaid. And the complication of the most important meal of the day.

SDR stands for 'Something Designed Ridiculously', by that wary combination of bureaucrat, politician, and academic. Well, actually it stands for 'Special Drawing Rights'. How's that for a description?

Special Drawing Rights are an artificial reserve currency. IMF members hold them as part of their reserves. They are not actually a currency though, they are basically a coupon that allows you to obtain certain foreign reserves, no questions asked, through a sort of reserves pooling arrangement among members. SDRs give access to "freely use-able" currencies, the most traded currencies in the world. Currencies that the majority of IMF member countries (including many developing countries) can quite easily obtain on their own anyway, without coupons, by simply borrowing or running a balance of payments surplus with a reserve country or jurisdiction. Or else through lines of credit administered by the IMF, or even central bank swap lines. These methods are subject to market and economic discipline, though, unlike SDRs, which can actually be used as cheap financing for budget deficits, and never needing to be paid back. 'Supporting Deficit Reduction'.

The SDR has its origins in the twilight of the Bretton Woods era, where the US dollar was fixed to the price of gold and considered the international reserve currency. Having a sovereign currency act also as an international reserve currency, though, is fraught with conflicting aims on both the issuer and borrower side. And linking economic growth to the supply growth of a single commodity seems bizarre in hindsight. With the Bretton Woods agreement, these issues came to a head in the late 1960s. Scarcity of the international reserve asset was becoming an issue and needed to be addressed. The underlying issue was really the design of the monetary system itself. The boat had holes on the sides and was sinking. Enter the IMF and SDRs - band-aids for for the bullet holes (apologies to Taylor Swift).

The SDR was intended to support international reserves, as clearly the supply of USD and gold were not keeping up with economic growth and hence demand for reserves. SDR came to the rescue in 1969. But soon after, the US started ramping up spending for the Vietnam war. Supply of USD reserves was no longer a problem. And then as US spending kept ramping up, countries began questioning whether the US could redeem the increasing supply of dollars for gold at the fixed rate. Within two years of the introduction of the SDR, the US was off the gold standard and the new monetary order of variable exchange rates began to take shape. SDR was DOA. Or was it?

Rather than leave the party in the early morning, the IMF decided to move in to the house. They redefined themselves, with the understanding that reality (US as international reserve currency) was unsustainable (or at least unstable), and fantasy (SDR can continue to support reserves and one day become the international reserve currency) made the most sense. 'Such Delusional Reasoning'.

(At this moment, I should pause and let the reader know that SDRs do play a very important role as unit of account for determining the maximum liability for damages for baggage lost, damaged or delayed on international flights. True story. So one could reasonably argue that SDRs have indeed taken flight).

Now allow me to try to explain how SDRs actually work.

First, they are priced in terms of a basket of currencies. The same basket of currencies for which the SDR can be redeemed. But confusingly, even though the SDR has an exchange rate, it isn't a currency as I mentioned earlier, but a coupon that allows countries to obtain any of five major world currencies. But in practical terms, it means access to the US dollar or sometimes the Euro. Because that is the reality, not the fantasy.

The IMF allocates SDRs to member countries based on each member's quota (i.e. financial commitment to the IMF), and then in turn provides the member with an identical holding of SDRs. The IMF then pays interest on the holdings, and charges interest on the allocation, which nets to zero. Because obviously.

If you purchase additional SDRs through this arrangement (i.e. from another member), then your holdings exceed your allocation and you are compensated on a calculated short-term rate for the difference. If you sell SDRs (to purchase US dollars), then your holdings are less than your allocation and you are charged a rate on the difference.

As an analogy, imagine someone knocking on your door representing the IMF - the International Milk Fund. You are in luck! As a milk drinker, you are part of the fund. We are allocating ten Special Dairy Rights to you which you must pay interest on, and giving you ten Special Dairy Rights which will pay you interest. So status quo, except milk.

If you want a bag of milk, you can sell a Special Dairy Right, no questions asked, and you'll receive a bag - in a few days. And you will be charged interest unless you buy back that Special Dairy Right, which you can do by giving back a bag of milk.

Got Milk?

Now here's the catch. We ask that if another of our members wants a bag of milk, that you give them a bag of milk. You'll get an additional Special Dairy Right for which we'll pay you interest. And you can always sell that dairy right it to someone else to get your milk back - which will take a few days.

This is all kind of like the convenience store sign you sometimes see near the cash register - "have a penny, leave a penny, need a penny, take a penny".

Wait a second, you say. If I need milk, I'll just go to that convenience store and get some. Same day. I can afford a bag of milk, as can the majority of IMF members. And if I can't afford it, I can work out a deal with a dairy farmer. And for those few countries that do not have these options - can't we tailor a lending scheme or swap line with these specific countries to assist in their balance of dairy deficits or reserve needs, without drawing in everyone and their uncle? Hey, maybe that's why they're called drawing rights.

Alas, there remain loyal soldiers who continue to see potential for the SDR, even arguing to further increase SDR allocations to levels meaningful enough to take on the USD as an actual reserve currency. Even though the recent boost in allocations during the financial crisis has essentially been meaningless. Or maybe the SDR can transform to a global digital currency, less volatile than any single currency, and even issued privately. Even though central banks around the world are exploring digital currencies and how to improve cross border payments without even considering leveraging the SDR, and the private sector is moving full speed ahead on their own ideas for stable coins and other payments innovations, leaving the SDR as the bridesmaid that has never been able to catch the bouquet.

So ultimately, what will the legacy of the SDR be? My money is on SDRs being viewed as evidence of the inertia and impracticality of thought generated by international institutions with too many cooks in the kitchen, and too much politics. "So Disappointing, Really.