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What are Special Withdrawal Rights (SDRs)?

Published by honor in category Precious Metal Information Guides on 19.02.2024
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When we imagine a country’s reserves, it’s common to picture a secure vault filled with stacks of currency and gold. While this representation is widely promoted, and it’s true that foreign exchange and gold constitute crucial financial assets for nations during crises, they are not the only resources at their disposal. Alternatives include government or corporate bonds, stocks, real estate, and Special Drawing Rights (SDRs).

SDRs, however, receive scant attention in public discourse and are even less understood. To address these issues, this article aims to demystify what SDRs are and highlight their significance.

What are SDRs?

Special Drawing Rights are a reserve instrument created by the International Monetary Fund in 1969. According to the IMF, SDRs are:

The SDR is an international reserve asset created by the IMF to supplement the official reserves of member countries

SDR is not a currency. It is a potential claim on the freely usable currencies of IMF members. Thus, the SDR can provide liquidity to a country.

In simpler terms, the SDR is an asset whose value depends on a basket of five major currencies . Each included currency has its own share of the SDR value, depending on the currency’s importance internationally in foreign exchange payments and transactions. However, since their creation in 1969, the SDRs have been amended at each IMF decision, which is taken once every five years. In this way, the IMF wants to ensure that the value of the SDR reflects global economic developments.

Initially, SDRs were entirely based on the US dollar, with a backing of gold at a rate of $35 per troy ounce. Yet, the launch of the SDR occurred alongside the United States’ diminishing capability to fulfil its obligations under the Bretton Woods Agreement, established in 1944.

The more difficult it was for the US to honour its gold payment for dollars held by countries such as France and Great Britain, the greater the need for an alternative to facilitate international transactions. The idea of ​​creating an asset represented by several currencies seemed an easy one, as it minimised the risk of fluctuations in currency exchange rates. At the same time, given the IMF’s global operations, the institution needed a fair measure for accounting for various transactions.

It’s crucial to understand that these rights are not currency issued by the IMF (despite having the symbol XDR, similar to USD, EUR, GBP, etc.). They cannot be directly used to purchase goods or services. Instead, they serve primarily as a form of financial guarantee.

How to Create and Use SDR?

The issuance of SDRs is an exclusive function of the IMF, facilitated through processes known as “General Allocations.” During each allocation, the IMF essentially generates financial instruments from thin air, which lack backing by any entity or asset. In other words, when an SDR is created, it does not involve physically depositing the equivalent of 1.32514 US dollars (the value of one SDR on February 12, 2024) into a vault.

Allocations of SDRs have taken place historically, especially during periods of crisis, driven by countries’ need for liquidity. The creation of SDRs out of thin air enables nations, whose currencies are included in the SDR’s valuation, to generate substantial amounts of money. This is because the funds generated are not limited to the issuing countries alone but also benefit those in dire need of financial resources.

More on the subject here: What is inflation?

The most significant allocation occurred in 2021, amounting to the equivalent of over 650 billion US dollars. This was aimed at mitigating the severe impacts of the pandemic.

How Can SDRs be Used?

SDRs act somewhat like collateral, and indeed, their direct use for payments is limited to obligations towards the IMF, such as membership dues or settling various debts. Beyond these specific uses, they essentially represent outstanding debts not backed by any party.

To leverage these instruments for practical purposes, countries must convert them into currency through the following process:

  1. A country requiring currency (for instance, to fulfill payments to its trading partners) and holding SDRs may offer them for sale.
  2. Another country, possessing surplus foreign exchange reserves, might choose to purchase these SDRs, providing in exchange one (or more) of the currencies that constitute the SDR’s value.
  3. The selling country then uses the received currency to meet its payment obligations, while the buying country adds the acquired SDRs to its reserves.

Notably, if a country in need of liquidity cannot find a buyer for its SDRs, the International Monetary Fund (IMF) will designate a member state to purchase those assets.

Why Would Countries Buy SDRs?

The IMF has pondered over this very question and devised a solution by introducing an interest mechanism for SDR allocations. Beneficiary countries are charged interest on their allocations, yet, if they do not utilize their SDRs fully, they earn interest on the remaining balance. The interest rates for both paying and receiving are identical, effectively nullifying each other.

However, for nations whose SDR holdings fall short of their total allocations, the interest charges result in a net expense, acting as a form of pressure. Conversely, countries with SDR holdings exceeding their allocations benefit from net interest earnings. This system of interest payments is known as the SDR interest rate (or SDRi), calculated based on the weighted average of the short-term government bond rates of the currencies constituting the SDR’s value, including those of the four countries and the euro area.

The United States holds the largest reserve of SDRs, amounting to 117.46 billion SDRs (equivalent to over $155 billion), showcasing the influence of the “one dollar, one vote” system. This is starkly evident when compared to India, a country with a population more than four times that of the U.S., which only has 13.65 billion SDRs (about $18 billion).

These figures pertain to deposits, with each central bank managing its own fluctuations independently. However, the disparity extends to allocations as well. In 2021, the U.S. received more than 79.5 billion SDRs in allocations, while India received five times less, at 12.57 billion SDRs. Regrettably, this is just one instance of the unevenness observed in the system.

The SDR Paradox

The IMF’s original intent was to enhance liquidity for nations in need, yet it inadvertently established an inequitable system through the imposition of interest

This term could be coined the “SDR paradox”, highlighting the oversight of certain scenarios in SDR transactions.

When a country is compelled to sell its SDRs, dropping below its allocation level, it transitions into a net interest payer – shelling out more in interest than what it earns on reserves. The crux of the issue lies in the circumstances compelling a country to offload its SDRs.

This scenario typically unfolds when a nation has to settle foreign currency transactions with trading partners, marking it as a net importer (where imports surpass exports). In an economy reliant on international trade, this forces the country to incur additional costs to utilize the instruments of an organization purportedly designed to support developing economies.

Reaching a juncture where a country faces interest penalties due to insufficient SDRs is no small feat. Central banks often counter this by generating more money to repurchase those currencies. Additionally, governments can issue bonds in currencies like the euro or the US dollar.

Nevertheless, there’s room for the IMF to reconsider and possibly adjust its interest rate framework for SDRs, to foster a more equitable system.

Is the SDR a Replacement for the US Dollar?

While the introduction and the rationale behind the creation of Special Drawing Rights (SDRs) might suggest that SDRs are akin to a new form of currency, they do not fulfil all the necessary conditions to be considered as such. For starters, no private parties, be they individuals or corporations, are entitled to claim these rights.

Delving deeper into the essence of currency, we find that SDRs’ applicability is significantly limited. As previously explained, SDRs function more as a financial safeguard than actual currency. Although the International Monetary Fund (IMF) conducts its accounting in SDRs, this practice has minimal impact at the macroeconomic scale. The primary goal of utilising SDRs in accounting is to facilitate a more tangible representation of the Fund’s international operations, rather than to serve as money in the traditional sense.

Key Takeaways

Throughout this article, we’ve explored how the Special Drawing Right (SDR) is a financial mechanism established by the International Monetary Fund to bolster liquidity for its member states during critical times of need. While the initiative is commendable, there are instances, such as the paradox I highlighted, where the application of SDRs may inadvertently disadvantage the very countries seeking to utilise them.

Over its 55-year history, the valuation of Special Drawing Rights has relied on the currencies of the world’s leading economies. The move away from gold in 1971 was driven not by a scarcity of gold for settling debts and boosting savings but by a fundamental misunderstanding. The real issue was that gold enforced fiscal discipline upon governments, a constraint that clashed with the ambitions of various political leaders.

Gold price (XAU-GBP)
1,860.66 GBP/oz
  
- GBP0.28
Silver price (XAG-GBP)
22.49 GBP/oz
  
- GBP0.16

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