Present Context
International Monetary Fund (IMF) has increased the weighting of the USD and Chinese Yuan in its first regular review of the SDR evaluation. The Chinese currency, Yuan, was included in the basket in 2016 only.
This weight increase will enhance the Chinese Yuan’s status as an international currency and increase the appeal of yuan assets. This prompts the Chinese central banks to push for a further opening of their financial markets and simplify the procedures for foreign investors to invest in the Chinese market and improve the business environment.
Let’s start from the beginning
Every country has foreign currencies it uses to pay for imports. Sometimes these currencies are not sufficient. So nations end up taking loans with high-interest rates. But SDR is a cheaper way to raise funds. They are like assets used by nations to buy hard currency at comparatively low interest.
But who gives you cash in exchange for SDRs? The answer is any country that wants to buy SDR. SDR is an asset, after all, that can be exchanged for hard cash anytime.
IMF gives SDRs to each country as per their quota. IMF quotas are based on the relative economic position of the country in the world economy. The problem with the SDR allocation is that richer countries receive more than poorer countries. Therefore, countries like the U.S., which can print its money, and China, which has several trillion in reserves, benefit the most.
What would help in this situation is if these countries were moved by generosity to donate a portion of their SDRs or yield their quotas to less-developed economies. However, this is a policy issue that is frequently mired with political considerations.
There is a difference between lending and donating SDRs. If countries lend their SDRs, they still remain an asset to the country. As with any lending, SDRs may earn interest and have some prospect of being returned after the life of the loan but can incur some risk of non-repayment.
IMF has only allocated SDRs four times, the latest one (the figure of $650 billion), in 2021, as a response to the Covid-19 crisis. Because the Trump administration did not support the allocation, it was put on hold until the Biden administration took office, allowing it to proceed. The allocation took place in August 2021.
But only 3 percent went to low-income countries. Therefore, the countries in greatest need were not the top beneficiaries of the SDRs.
SDR can be converted into five currencies: Dollar, Euro, Chinese Yuan, Japanese Yen, and British Pound Sterling.
So, how are SDRs distributed to countries? They are initially allocated to member countries, and each member is given two positions: – “SDR holdings” and “SDR allocations.” Countries receive interest on their holdings and pay interest on their allocations position.
In the beginning, the two positions, “SDR holdings” and “SDR allocations,” are equal, and interest received, and interest paid cancel each other out. But as the country trades more SDRs for currencies, its holdings decrease and fall below allocations which means it now pays more interest than it receives. The interest is paid to the IMF.
In more simpler terms, nations convert their SDRs into hard currency and don’t have to pay back that hard currency by any specific deadline; they just have to pay any interest owed to the IMF.
Developing economies are the primary users of Special Drawing Rights (SDRs) and are much more dependent on them than developed economies. More than 70% of the 190 IMF participant economies are under pressure, with SDRs holdings below their SDRs allocations. The IMF makes allocations over time, sometimes generally and sometimes in case of special circumstances.
SDRs provide a direct liquidity boost to developing countries without raising debt burdens.
Points to remember
- The IMF was established along with the World Bank after WW2 to assist in the reconstruction of war-torn countries.
- SDR, an international reserve asset, was created by the IMF in 1969.
- SDRs are reserves held by IMF that can be used to respond to the global economic crisis.
- The SDR value is calculated daily, and the valuation basket is reviewed and adjusted every five years.
- SDRs belong to individual countries, not to the IMF. Each IMF member country has been allocated a certain amount of SDRs, which are held at the IMF in the country’s SDR account.
- SDR allocations are ‘free.’ An SDR allocation involves two elements: an allocation of SDRs (liabilities) and matching SDR holdings (assets). The SDR Department pays each member interest on SDR holdings and levies charges on SDR allocations. Therefore, an SDR allocation is ‘cost-free’ for all its member nations because interest and charges net out to zero if the countries do not use their SDR allocations.
- The use of SDRs is not ‘cost-free.’ The use of SDRs occurs when a country reduces its SDR holdings vis-à-vis its SDR allocation.
- An example for understanding: If country ‘A’ received SDR 50 billion as part of a general IMF allocation, it would, at that moment, have an allocation of SDR 50 billion and also a holding of SDR 50 billion. On its allocation, it would be required to pay interest to the IMF’s SDR Department, and on its holding, it would receive interest from the SDR Department. Because ‘A’s allocation and holdings of SDRs are currently equal (SDR 50 billion), the interest that ‘A’ receives and pays exactly cancels each other out. However, if ‘A’ decides to convert some of its SDRs into another currency, then its holdings of SDRs will decrease. If ‘A’ converts SDR 10 billion into U.S. dollars, its holdings fall to SDR 40 billion, while its allocation (the amount officially credited to ‘A’ by the IMF) remains at SDR 50 billion. In this case, ‘A’ will now receive less interest than it pays, and it will end up paying out annually to the IMF.
- SDR is a low-cost method allowing members to reduce their reliance on more expensive domestic or external debt.
- SDRs general allocations occur very rarely, and the IMF has done so only four times in its history: in 1970-72, at the time of the establishment of SDRs; in 1979-81; in 2009, to help in the recovery from the 2008 financial crisis; and the latest one, in 2021, as a response to the Covid-19 crisis.
- There appears to be a global political consensus that wealthy countries, as well as some middle-income countries with large reserves, do not require the additional SDRs right now. They are unlikely to convert their SDRs into hard currencies, limiting the scope of the global sharing agreement.
- An example for understanding: A country ‘A’ has seen a drop in the value of its export and thus is short on the U.S. dollars it needs to pay for vaccine imports, which are needed immediately. ‘A’ has 20 million SDRs in its account at the IMF, and it approaches the IMF to exchange its SDRs for dollars. The IMF approaches a rich country, ‘B,’ which has plenty of dollars at its central bank. ‘B’ agrees to give ‘A’ U.S. dollars in exchange for ‘A’s’ 20 million SDRs. ‘A’ then has enough dollars to buy its needed vaccines. This exchange gives B the power to buy more hard currency in the future when needed in the amount equivalent to 20 million SDRs. It is worth noting that neither A nor B’s total foreign reserves have changed as a result of this exchange; all that has happened is that ‘A’ has exchanged SDRs, which were no longer usable for vaccine purchases, for dollars for which ‘B’ had no immediate use. ‘A’ is, however, now able to buy vaccines.
- SDR is a reserve sharing mechanism. They are not money in the conventional sense because they cannot be used to purchase real goods.
- The IMF has the authority to call upon its members with strong holdings positions to purchase SDRs from members with weak holdings positions.
- The IMF has allocated a total of SDR 660.7 billion ( approximately US$935.7 billion). SDR 456.5 billion (approximately US$650 billion) was allocated on August 23, 2021, by far the largest allocation to date. In addition, new members of the IMF receive an SDR allocation upon their participation in the SDR Department.