Special Drawing Rights-SDR

The SDR is an international reserve asset, created by IMF in 1969 to supplement its member countries official reserve. This instrument was created basically to support the then existing Bretton Woods fixed exchange rate system. To maintain a fixed exchange rate each country has to maintain the asset reserve, but USD and gold the proved to be inadequate measure to peg the currency. So SDR was created under IMF. But with the failure of Bretton Woods system the need for SDR reduced. Now in addition to its role as a supplementary reserve asset it serves as a unit of account of the IMF and some other international organizations.

How SDR value is defined?
Initially SDR was defined as 0.888671 grams of fine gold which was equivalent to one US dollar. After the collapse of Bretton Woods system in 1973, SDR was redifend as a basket of currencies. Today it consist of Euro, Japanese Yen, pound sterling and US dollar. The prices are based on London market value.

SDR interest rate:
The SDR interest rate provides the basis for calculating the interest charged to members on regular IMF loans, the interest paid to members on their SDR holdings and charged on their SDR allocations, and the interest paid to members on a portion of their quota subscriptions. SDR is the weighted average of representative interest rates on short term debt in the money market of the SDR basket currencies.
SDR allocations provide each member with a costless asset. If a member’s SDR holdings rise above its allocation (for example, if it purchases SDR from another member), it earns interest on the excess; on the other hand, if it holds fewer SDR than allocated, it pays interest on the shortfall at the official SDR interest rate.

Buying and selling SDR’s
IMF members often need to buy SDR’s to discharge obligations to the IMF or they may wish to sell SDRs in order to adjust the composition of their reserves. The IMF acts as a broker between members and prescribed holders to ensure that SDRs can be exchanged for freely usable currencies. Earlier trading was voluntary.
In the event that there is insufficient capacity under the voluntary trading arrangements, the Fund can activate the designation mechanism. Under this mechanism, members with sufficiently strong external positions are designated by the Fund to buy SDRs with freely usable currencies up to certain amounts from members with weak external positions. This arrangement serves as a backstop to guarantee the liquidity and the reserve asset character of the SDR.
Although there are no notes or coins denominated in SDR, it acts as a interest bearing international asset.
The allocation of SDR by the IMF boosts member countries’ reserves because they can be turned into usable currencies. Once the SDR have been added to a member country’s official reserves, the country can voluntarily exchange its SDR for hard currencies, such as the US dollar, euro, yen, or pound sterling, through voluntary trading arrangements with other IMF member countries.
In view of the expected increase in the volume of transactions following the 2009 SDR allocations, the number and size of the voluntary arrangements has been expanded to ensure continued liquidity of the voluntary SDR market.

With the world still in recession, in Aug 2009, IMF, to booster its member countries reserve, allocated new issue of equivalent 250 Billion US Dollar, followed by another issue of 33 billion US dollar of SDR in September 2009. This created an outstanding SDR of total 316 billion US dollar. The allocation is based on a long-term global need to supplement IMF members’ existing reserve assets and it provides liquidity to the global economic system. Before this decisions to allocate SDRs have been made only twice. The first allocation was for a total amount of SDR 9.3 billion, distributed in 1970-72. The second allocation was distributed in 1979-81 and brought the cumulative total of SDR allocations to SDR 21.4 billion. And both times there was a huge inflation exactly at that time. And SDR was termed as monetary kerosene at that time. So will there be another inflationary year after the recession?

Another argument that is in favor of SDR is the debate over replacing the US dollar as the world’s reserve currency. Shortly after IMF declared the new allocation of SDR to its member’s, UNCTAD joined the debate over replacing the US dollar as the reserve currency. In its report published in September said that the trade imbalance and the breakdown in the way currencies and capital rules work was largely responsible for the financial crisis. In effect, it is suggesting that a new composite or artificial currency be created, that would be a weighted basket of major currencies. In other words, rather than having the US dollar as the sole reserve currency, the new system would bring in a range of currencies that should balance out into a more stable system* .
The most probable candidate for the artificial currency is SDR. Many have welcomed this move as it would bring stability to the capital market by reducing the dependency on one single currency. But how long it would take to implement this? and how much it would cost in terms of inflation? .


Ref:
* http://en.mercopress.com/2009/09/10/unctad-joins-the-replace-the-us-dollar-debate
IMF: http://www.imf.org/external/np/exr/facts/sdr.htm