Global Reserve Assets – Move over US Dollars, SDRs are coming to town

Welcome to Finance and Fury, The Furious Friday edition. 

In money system – need a reserve – gold, currency – gives a floor value which gives confidence

1. Doesn’t provide much stability – Most central bankers use the same terms when talking about current international financial system – Incoherent –
   1. You have the AUD to USD drop, gold moves one direction, – completely disjointed – based around the models of international finance – not what they predict will happen – but still trying to manage
2. Floating currencies are not stable – financial war easier – There has been a currency war going on since 2010
   1. Remember QE – US dollars and treasury issues – what happens if your currency is pegged to USD?
   2. China – had to massively increase their money supply as well to keep currency exchange low –
   3. US growth from consumption, while China growth from exports – Yuan goes up, exports down
   4. But printing a lot of Yuan created inflation in china, along with the rest of the world – food, oil, commodities, USD is a form of global currency that assets are priced in
   5. If domestically you are experiencing inflation (or real devaluation of your currency) – price of food goes up
3. Think about any financial asset – shares, property, bonds, gold, cash
   1. Each behaves differently in crash – shares go down, bonds gold go up, etc – but they are all priced in AUD
   2. If you crash AUD – our international buying power and wealth goes down – global system very fragile
   3. Very controlled – One country can devalue its currency to make it more competitive – has to be done slowly over time
   4. Think that is what the RBA is trying as well – based on theory – interest rates drop = carry trade = exchange rates change and drop due to interest levels here – but over time – demand for goods (now cheaper) go back up bringing currency with it
   5. Theory doesn’t work out so well – due to incoherent natures of currencies – Confidence – and that currencies of other countries are used as reserves

What solution does the IMF see for its Reserves and stability of financial system problems?

1. Gold? – but the price of gold would need to be pegged to USD$10k per ounce to form a currency reserve
   1. Hard to get enough – been trying – mining ramped up, China and Russia massively buying up gold
      1. Has every bar melted into new bullion to avoid fakes – fake gold going around
   2. But IMF have SDRs – China needed to hold a lot of gold to be accepted into the currency basket of Special Drawing Rights (SDRs)

Special drawing rights are supplementary foreign-exchange reserve assets – IMF wants it as an international reserve asset

1. SDR is the unit of account for the IMF – “The SDR is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members.” – what does that even mean?
2. SDRs represent a claim to currency held by IMF member countries for which they may be exchanged – but only within the Financial System – There is no secondary market – unlike other forms of reserves/assets – bond etc
3. SDRs originally a part of the monetary system – Bretton Woods arrangement post WW2.
   1. USA had almost all of the gold reserves of the world at that time – other countries left with little
4. SDRs were intended as a supra-national currency that could be used instead of gold, thereby reducing dependence on gold (essentially the USA) – IMF first issued in 1969 to supplement its member countries’ official reserves (i.e. gold)
5. Today – SDR 204.2 billion (equivalent to about US$291 billion) have been allocated to members, including
6. 2009 – SDR 182.6 billion allocated in the wake of the global financial crisis –  to “provide liquidity to the global economic system and supplement member countries’ official reserves”.
7. The SDR was initially defined as equivalent to 0.888671 grams of fine gold—which, at the time, was also equivalent to one U.S. dollar. After the collapse of the Bretton Woods system, the SDR was redefined as a basket of currencies – floating currencies in the end
   1. China and Russia are storing Gold and urging the IMF to replace USD as the global currency reserve with SDRs
   2. Don’t like the reliance on USD as China and Russia have been on the raw end of the US Fed and Treasury
8. Price based on a combination (weighted average) of multiple currencies – The IMF has its own reserve which has multiple currencies
   1. basket is reviewed every five years – reflect the relative importance of currencies in the world’s trading and financial systems – currency weights remain fixed over the five-year SDR valuation – but values with cross-exchange movements daily
   2. United States Dollar – 41.73%, Euro – 30.93%, Japanese Yen – 8.33%, Pound Sterling – 8.09%, China – 10.92%
9. Interest rates – weighted average of all the currencies

Why are Special Drawing Rights (SDR’s) Required?

1. to move away from the United States dollar-based system – which has already way too much debt – $22trn debt
   1. If the USD collapses (as it isn’t money but built on $22trn of debt and agreements) – world suffers
   2. Large consumer but wouldn’t be able to buy –
   3. would require monetary restrictions – leading to global liquidity issues
   4. Just the value drop – We buy US shares – Share values drop – purely based on AUD versus valued in USD
      1. USD to AUD $1 – own a share worth $100USD – USD goes to $2 per AUD – shares worth $50
   5. These rumours suggest that these countries propose that Special Drawing Rights (SDRs) become the de-facto reserve currency of the world – avoid this risk
   6. Due to the USD being a global currency reserve – countries forced to hold it as part of their reserves – more risk

China – During the last review concluded in November 2015, the Board decided that the Chinese renminbi (RMB) met the criteria for inclusion in the SDR basket. Criteria:

1. Exports – one of the top five exports in the world and member of the IMF
2. Freely usable currency by the IMF- widely traded to make payments for international transfers
3. fully aware of the fragile economic condition in which the United States economy stands
4. forced to buy more and more United States treasury debt if it wants to keep its own economy afloat
5. A lot of excess USD in their trillions or reserves – Hope to solve these problems with SDRs – still buy 41%

Benefits of the Special Drawing Rights (SDR’s) System – These are based around if the model actually works

1. Reduced United States Dependence – no longer have to depend on the currency of United States to trade with each other
2. More Stable System – Since essential commodities such as gold, oil and food grains will no longer be exclusively traded in dollars, the United States government will not be able to exert an undue influence on their prices by increasing and decreasing the money supply of dollars as much – minimalizes their effect
3. Balance of Payment Issues: If the world were to go off a dollar-based system it would resolve a lot of balance of payment issues that are being faced. The United States is running a perpetual trade deficit with countries like China.

Disadvantages of the Special Drawing Rights (SDR’s) System

1. Money Supply Becomes An Administrative Decision: If Special Drawing Rights (SDRs) become the reserve currency of the world, then the IMF would be in charge of regulating the money supply – for the whole world –
   1. would not have an open market of their own, the decision regarding whether the money supply should be expanded or contracted would end up becoming an administrative decision –
   2. The fact that all other economic parameters are extremely sensitive to changes in money supply, this is a dangerous situation to be in.
   3. Under the Articles of Agreement, when certain conditions are met, the IMF may allocate SDRs to members participating in the SDR Department in proportion to their quotas (known as a general allocation). A special one-time allocation in 2009 enabled countries that joined the IMF after 1981 (i.e., after previous allocations) to participate in the SDR system on an equitable basis.
   4. Members can buy and sell SDRs in the voluntary market. If required, the IMF can also designate members to buy SDRs.
2. Abstract Nature: The Special Drawing Rights (SDRs) are an abstract weighted average. They are not an actual currency that can be used by people. As such, Special Drawing Rights (SDRs) will be extremely difficult to implement and manage, if they are ever introduced at the microeconomic level.
   1. The SDR mechanism is self-financing and levies charges on allocations which are then used to pay interest on SDR holdings – so IMF creates SDRs based on deposit currencies, loans them to a country and then the country needs to pay it back
   2. This is the current reserve system on crack
3. Still have currency backing it:  replacing dollars with Special Drawing Rights (SDRs) would be like replacing one unstable system with another slightly less unstable system
   1. Nothing to stop the expansion of debt to fund projects
4. SDRs serve as the premier mode of transfer for IMF loans to member nations in need of financial assistance
   1. SDRs are allocated via endowment or credit at the discretion of IMF authority while adhering the governing Articles of Agreement. The cost of borrowing, or yield to depositing, from the IMF is determined via the SDR Interest Rate (SDRi) – they will become the payday lenders of the world – predatory lending
   2. the IMF increased lending capacity to 690 billion SDR – in anticipation of global spending projects
   3. There are already agreements in place to dish out the loans – money created from the issue of SDRs – infrastructure projects across the world
5. What projects going on? UN and their sustainable development goals – SDRs fit into this – need a global boost in the money supply to fund projects
6. Studies and papers published on the benefits of issuing special drawing rights to low-income countries – part of infrastructure spending by the Governments
   1. Come back to this in the series on the UN Sustainable development goals – one part of the pie

The Bottom Line

1. Special drawing rights are a form of world reserve asset – value is based on a basket international currencies
2. SDRs are used by the IMF to make emergency loans and are used by developing nations to shore up their currency reserves without the need to run current account surpluses at the detriment of economic growth –
   1. Real part of the design – to make sure the high export countries don’t experience currency appreciation due to demand for goods
   2. Allows for a country to boost reserves (from a loan) to then increase their money supply and remain competitive
   3. German in EU example – strong exporter but EUR doesn’t reflect this – but on larger scale than just EU
3. can only be accessed by members of the IMF- Central banks or nations who are members and play by rules
4. Trouble is – I think most countries want this –
   1. China – still remains an exporter through lower inflation and still able to increase money supply to keep up with US increases
   2. Euro – China and USA are big trading partners – to make sure the Euro doesn’t collapse
   3. USA – want to avoid a currency collapse – as long as they stay the major economy still have largest weight of SDR – keep the game going
   4. Japan – Had no growth and inflation over a long time- been printing trillions of Yen – pumping into hard asset prices – but not enough inflation to start eroding their 240% debt to GDP

Studies and papers published on the benefits of issuing special drawing rights to low-income countries – part of infrastructure spending by the Governments

https://link.springer.com/article/10.1007/s11079-011-9232-2

https://www.imf.org/en/About/Factsheets/Sheets/2016/08/01/14/51/Special-Drawing-Right-SDR

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