Wednesday, August 24, 2016

SDR Denominated Bonds Coming- What response will we see?

With the upcoming G20 meeting expected to call for looking at ways to encourage broader use of the SDR, we are seeing news headlines about the issuance of new SDR denominated bonds. Earlier we ran this blog article to provide a simple example for how an SDR denominated bond might work in the real world.  

These headlines spur all kinds of speculation in regards to possible dramatic announcements about major monetary system change. Since we watch for that here, it's of interest for sure. But we need to understand the reality of what is actually happening and also the challenges the SDR still faces to broader adoption in the future. 

This news about new SDR bonds is important because it is somewhat of a first step towards a more broadly accepted SDR. But as we can see from this article in the Nikkei Asian Review, there is still a long road ahead for the SDR. The first thing to watch for is what kind of market reaction there is to these new SDR bonds. 

Below are a few excerpts that talk about this and some added comments. I submitted this article to IMF and SDR expert Dr. Warren Coats to see what he thought. He reviewed everything below and then offered his thoughts in red type. I am including his comments in red below as I think this will give you a very unique opportunity to see what a true expert thinks. Note how he points out a couple of errors he sees in the Nikkei Asian Review article. Dr. Coats also provided me this direct quote to include with this article:

"I fully agree that short of a real crisis, developing and expanding the role and use of the SDR will be a gradual step by step process. The development of private SDRs, for example, requires no decisions by the IMF at all if the existing currency basket is used. This was the topic of my "Asian Infrastructure Investment Bank and the SDR” article."  ----  Warren Coats


With the yuan set to enter the Special Drawing Rights currency basket in October, China looks to create a market for SDR-denominated bonds as a step toward internationalizing the country's currency. [building SDR instruments is more about replacing the USD than internationalizing the RMB] -WC

The government-linked China Development Bank as early as this month (August) will issue $300 million to $800 million in notes denominated in the International Monetary Fund's reserve currency, with maturities of around six months. This will mark the first float of SDR-denominated bonds by an individual financial institution." [I am pretty sure there were some in the early 1980s as well as SDR denominated bank deposits]-WC
. . . . . 
"President Xi Jinping hopes to cite a successful SDR bond float as progress toward the yuan's internationalization when G-20 leaders meet next month in Hangzhou, China. But whether a substantial market exists remains an open question. The SDR's value is based on multiple currencies, making hedging against currency risk complex and costly. [there is nothing complex about it but as it involves 5 currencies rather than one, it will be somewhat more costly]-WC The government's decision to opt for short-term bonds was likely based on the assumption that buyers would hold the notes until maturity."
Investors are also unimpressed with the coupon. The bonds likely will pay an annual rate of just 1% or so, a major bank said, though this will depend on demand. Given the costs involved, many banks likely would end up losing money. Cultivating a market for the instruments will require heeding investors' opinions.
Beijing's strong push for SDR-denominated bonds could lead to some purchases by Chinese banks and foreign banks operating in the country. But the lack of past floats by U.S. or European financial institutions suggests that potential demand is thin." [which is why I have recommended starting with invoicing oil and other internationally trading commodities, as well as the activities of the IFIs in order to build real demand for SDR asset]-WC


My added comments: There are several points of interest in this article for me. Here is a quick bullet point list: 

- SDR Bond issuance is a significant event that may signal larger future developments
- China seems more interested in this than the EU and the US (agrees with input I have gotten from a source I view as credible) [because they have long wanted to replace the USD in international reserves with a truly international asset]-WC 
-these first bonds will have a pretty short maturity because of the complex currency nature of an SDR denominated bond (based on 5 currencies)- not exactly market friendly

- interest rate of only 1% and banks that fool with this may lose money on it - not exactly a motivator for banks to get involved [but we don’t know the rate China will set or that will result from the markets biding]-WC

I think the challenges mentioned in this article for these new SDR bonds illustrates something I see in my own research. Many times we see headlines on all this that sound as if some major dramatic change to the monetary system is about to suddenly change the world. But once we get past the attention grabbing headline, the real world comes into play. It's still a big question what kind of market response these bonds will get. It appears that the US in particular is not enthusiastic at all about any changes that might lead away from the current US dollar centered system towards the SDR as a replacement. It will be interesting to see how the US and China behave at the upcoming G20 meeting in regards to whatever SDR news is announced. 

This reminds me of another similar situation. If you follow these issues, you often see headlines about how the SDR will replace the US dollar as global reserve currency and become the new "world money." I think most people envision this being like money they have now such as dollars or Euros. While that is indeed possible some day, here is a question worth asking when you see a headline like this: Exactly how in the real world would such an event take place? You cannot just wave a magic wand under current IMF rules and declare the SDR to be a new world money the next day like it sometimes sounds in these headlines. 

Under existing rules and the existing dollar heavy system, there are a number of issues that would have to be resolved to do anything like this. In the first place, you would need 85% approval for any IMF rule changes needed (with the US having veto power at 16%). Assuming you did get that, there are still many real world issues and challenges to deal with. I realized this when I read Dr. Warren Coats Real SDR Currency Board proposal. You don't have to read very long to realize that Dr. Coats lists a number of challenges to actually implementing an SDR based system (the nuts and bolts of actually making it work) and then proceeds to explain how he would deal with those issues to make it work. Here are just a few issues he raises himself in his own proposal for example:

- to do anything you must have broad political will and support 
-  the IMF Board would have to approve issuance of SDRs under a Currency Board (under   Dr. Coats proposal)
- IMF member approval to change the SDR valuation basket from a group of currencies to a basket of goods (under Dr. Coats proposal)
- Who would be allowed to hold SDR acccounts at the IMF? Dr. Coats explains his idea
- What assets would be accepted to issue or redeem SDRs? Dr. Coats covers this

- How would countries substitute their existing reserves for SDRs? He also covers this

The list goes on and on. In his proposal, Dr. Coats says these issues can be resolved with the approval of IMF members, but how long would that take and what if the US balks at it with 16% veto power at the IMF. The US held up the 2010 reforms for years before finally approving them in late 2015.

This is what you do NOT see in the attention grabbing headlines. Somehow, to get a true "world money" SDR that people could use like an actual currency, you have to have a real proposal that could actually be voted on approved by IMF members. A little detail that I feel gets overlooked many times in some articles I see on this topic. 

Another point of interest for me is that this proposal by Dr. Coats is the only actual proposal on the table anywhere that I know of for the IMF to consider to make the SDR like a real currency. To consider a different proposal they would have to deal with all the issues and challenges Dr. Coats points out in his own proposal. The IMF tends to move very slowly and all of this would take a lot of time. 

So, What could change this situation and speed up the process? I can only think of one thing. Another major crisis worse than 2008 where the major world powers decided that an emergency global meeting had to be held to deal with all this (a kind of new Bretton Woods). Under those circumstances there would be more urgency. Perhaps any approvals for rules changes needed would be easier to get. Or, if things were really bad and really urgent, perhaps they just suspend the existing rules and start out with completely new "rules of the game?"

This is why I think that unless we get this kind of new major crisis, we should not expect to see sudden and dramatic monetary system changes take place. Instead, the "piecemeal engineering" process (slow incremental steps) Jim Rickards talks about is more likely in a non crisis environment. As we see from Dr. Coats quote above, he tends to agree and mentions the expansion of "private SDRs" as an example of a small incremental step.

All this has led me to conclude that there are really just two main events to watch for here:

1- Another major global financial crisis worse than 2008 that could create urgency 

2- The various possible proposed "solutions" to any such crisis that exist now and that have a realistic chance to actually be considered for implementation.

We feature Dr. Coats Real SDR Currency Board proposal here because it is an actual serious proposal the IMF is aware of now. He has already done some work to raise the various issues and challenges to actual implementation that would have to be dealt with in any new proposal to use the SDR like a global currency (or "world money"). That would save some valuable time from the IMF's perspective under crisis conditions it seems to me.

If you were the IMF and were forced to deal with a huge major global crisis, what would you do? Start all over from scratch or look at an actual serious proposal already on the table from a recognized expert? Remember, time is of the essence and you don't have the luxury to study a brand new proposal for months or years. This is why I think anyone interested in all this should read and understand Dr. Coats proposal. In a time of crisis, it might get serious review and consideration.

Please keep this in mind when you see attention grabbing headlines on the SDR as "world money." The headlines are not necessarily wrong, but there are always "details to follow" and they do matter. 

Added notes: After reading the direct quote from Dr. Coats he gave for this article (after I wrote the part above), I should point out that his Real SDR proposal that I talk about would require some IMF rule change approvals which would slow things down. Dr. Coats points out in his quote above that these private SDR denominated bonds (now called M-SDRs by the IMF) would not require all this IMF approval process so long as they use the existing currency basket to value it. This is an important distinction and I am glad he mentioned it.

While these private SDRs could be used more easily and quickly, they still are not a "world money" type of legal tender currency private citizens could spend directly. This is why we feature Dr. Coats proposal here (which really could be implemented like that, but requires the rules changes). These different "kinds" of SDRs (official vs. private) do add some confusion to understanding all this.

These private SDRs as they are right now are really just a way to own the variety of currencies in the SDR basket (now five) by owning one bond. We could do somewhat the same thing by just obtaining the actual five currencies in the basket in the same ratio as they are in the SDR basket. Not really a monumental change as I would view it.

You and I could not spend a private SDR (or M-SDR) anywhere as legal tender as far as I know. First you must convert it back into a legal tender currency or currencies to be able to spend it. So I don't view this initial expansion of private SDRs as the kind of monumental monetary system change we watch for here. Instead, I think of them as more like a first step towards (see more here) the concept of an SDR as money like most people would think of it (like a US dollar or a Euro or a Japanese Yen).

For this to morph into a true legal tender version of a "world money" that anyone could own and use without having to convert it back into existing currencies (what we watch for here), you would still need the kinds of IMF rule changes Dr. Coats talks about in his "Real SDR" proposal. That is why I feature it here. He has the ONLY serious proposal I know of that provides a path to this kind of "Real SDR" anyone could own that could be considered by the IMF at this time. If someone does know of another real actual proposal like that, I would be interested to know about it and would cover it here. This is the last of our three part series of articles on the SDR leading up to the G20 meeting.

Update 8-25-16: South China Morning Post runs this article on the upcoming SDR Bond issue providing more details.


  1. Really a nice meter of this post. I read your post. Thanks for share your post with us.

    Foreign Currency Exchange

  2. Nice write up Larry
    I think the most important feature of the IMF SDR program is the Substitution Account. Countries can use this feature to move away from USTs and into SDRs. This will help balance their reserves and hopefully reduce or eliminate the exported inflation due to the dollar and its reserve currency status
    Thanks again for all your efforts and insight

  3. Thank you G-Man. I agree that a substitution account would be a significant event which is why I watch for things like that. It's my understanding from Dr. Coats that would require 85% approval from IMF members and this has been hard to get in the past. But who knows what will happen in the future. I don't claim to at all.