Monday, March 7, 2016

Followup on IMF SDR - An Emerging Global Currency? More Details

Our article featuring the video discussion about the future potential for the SDR as a global reserve currency has generated a lot of interest and some good questions from readers around the world. Some readers here are advocates of a monetary system backed by gold so they wonder why the world would be better off using the SDR as a global reserve currency as Dr. Coats has proposed.

These are all good questions and encourage me that this blog is reaching one of its goals. A goal here is to present a variety of credible views on the important issues that relate to future potential monetary system change. In this case we have featured a presentation on how the SDR might eventually replace the US dollar as the world's global reserve currency and thoughtful readers raised some questions about why Dr. Coats thinks this is a good idea (see example here).  

In this followup article we will direct readers to a paper written by Dr. Coats where he explains in more detail why he thinks his proposal would make things better. Below I have pasted in the Conclusion section of his paper titled "Why the World Needs a Reserve Asset with a Hard Anchor". It may provide more insight into Dr. Coats thinking for readers here. Of course, you need to read the full paper to get the proper context. You can download the full paper here. Items that are underlined below are points I felt should have extra emphasis.

from the Conclusion section of "Why the World Needs a Reserve Asset with a Hard Anchor":


Since the collapse of the Bretton Woods/Gold standard system, the impressive growth of cross border trade and finance has been restrained by costly exchange rate volatility. An expensive industry has developed to hedge the related risks. Exchange rate manipulation, if not out right currency wars, have created political tensions and produced large international payments imbalances. Given the size of the U.S. economy and the depth and breadth of its financial markets, the use of the dollar has remained and even grown as the world’s primary reserve asset. But the continued failure of the U.S. government to address its unfunded liabilities, the traditional lack of concern by the Federal Reserve for the monetary needs of foreign users of the dollar, and faltering American leadership of the post WW II world order have increased discontent with and reduced confidence in the current arrangements. While gaining the exorbitant privilege of borrowing abroad in its own currency and the seigniorage from foreign holdings of its currency, the U.S. incurs the cost of deindustrialization caused by the chronic balance of payments deficits needed to supply the world’s demand for its currency, and the entire world incurs the cost of weakened monetary and fiscal discipline and hard to predict exchange rates

A much better system would replace national currencies for pricing and settling cross border transactions with an internationally issued currency, whose value was anchored to a small basket of real goods, and to which the exchange rates of all or most national currencies where firmly fixed. In 1969 the IMF created the Special Drawing Right (SDR) to supplement or replace the U.S. dollar in international reserves. Initially its value was fixed to gold but after the closing of the U.S. gold window, its valuation was fixed to a basket of key currencies. The Second Amendment to its Articles of Agreement obligated Fund members to make the SDR “the principal reserve asset in the international monetary system” (IMF Article XXII). 

However, the SDR suffered from several deficiencies and never caught on. The initial failure (since corrected) to charge interest for using SDRs (and to pay interest for holding them) tainted the SDR as a development aid instrument rather than a reserve asset. More importantly, the regulation of the supply of SDRs via the approval of periodic allocations to all members in proportion to their IMF quotas made it very unlikely that their supply would match their demand at their officially fixed value (based on a basket of key currencies). This necessitated administrative rules for their use, which seriously undercut their attractiveness as a reserve asset. 

While many simple and practical steps can and should be taken to promote the use of the existing SDR as proposed by one of us in many earlier articles and by Governor Zhou in his speech in 2009, we believe (along with Governor Zhou) that the SDR could be made a much better (and less political) unit of account by replacing its valuation basket of currencies with a basket of goods. All of this could be done under the IMF’s existing Articles of Agreement

However, with an amendment to the Articles of Agreement that replaced the allocation of SDRs with issuing them under currency board rules, the attractiveness of SDRs could be dramatically transformed. Rather than buying and selling SDRs for the items in its valuation basket (ala the gold or other traditional commodity standards), the IMF would sell and redeem these “real SDR” for the basket indirectly (against government or other AAA financial assets of equivalent value). Such an SDR, with a relatively constant real value, is likely to be adopted as the anchor currency for fixing the exchange rates of many if not most national currencies and to augment or replace the U.S dollar and Euro in countries’ foreign exchange reserves. The entire existing stock of central bank FX reserves could be swapped (substituted) for real SDR in one go.

So why haven’t such reforms been embraced? The United States is thought to want to hang on to the seigniorage it earns from supplying its currency to foreign holders while indulging in its exorbitant privilege despite the instability of its exchange rate as capital flows in and out in response to Federal Reserve monetary policy and world developments plus the growing risk of a Triffin Dilemma like loss of confidence. We argue here that the U.S. has not given enough weight to the cost of supplying its currency in the form of deindustrialization nor the cost in the form of global financial instability from excess leverage encouraged by unanchored monetary policies.

Claudio Borio and Piti Disyatat “have argued that the fundamental weaknesses in the international monetary and financial system stem from the problem of “excess elasticity”: the system lacks sufficiently strong anchors to prevent the build-up of unsustainable booms in credit and asset prices (financial imbalances) which can eventually lead to serious financial strains and derail the world economy. Reducing this elasticity requires that anchors be put in place in the financial and monetary regimes, underpinned by prudent fiscal policies.”  Our real SDR currency board proposals could remedy this excess elasticity. 

My added comments: 

If you are interested in getting a better idea for Dr. Coats thinking you can do so by reading his papers written over the years which you can find here. Also, we have covered Claudio Borio (BIS) that Dr. Coats mentions above here on this blog. Readers might find this paper by Mr. Borio of interest as well.

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