The Potential of the SDR for Improving the International Monetary System

Ariel Buira ¹

This paper focuses on the shortcomings of the current arrangements for the provision and distribution of international liquidity and how they affect the working of the adjustment process and the international trade and payments system. The case is made that despite the rapid growth of increasingly integrated international capital markets, the prevailing mechanisms for the creation and distribution of world liquidity result in a system that is economically inefficient as well as inequitable. To address the shortcomings of the current system, a proposal is developed based on an alternative arrangement, which combines the Fund’s ability to create liquidity through SDR allocations and its surveillance function, to distribute international liquidity according to estimated needs.

Shortcomings of the Current International Monetary System

Among the objectives of the International Monetary Fund as envisaged by its founders was “to assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions which hamper the growth of world trade.” Moreover, the IMF would “give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with the opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.”²

In 1969, 25 years after the Fund was established, the First Amendment of its Articles of Agreement expanded its responsibilities in matters concerning international liquidity through the creation of the SDR. The Amendment sought to deal with the international community’s dissatisfaction with a monetary order in which the main source of international liquidity was the U.S. balance of payments deficit, by enabling the Fund to increase existing reserve assets in a timely manner whenever the need arose. In this way, the Amendment laid the foundations for a more rational and effective mechanism to adjust the supply of international reserves to the requirements of the world economy.

However, 27 years later, little progress has been made, as only a minority of countries have adequate access to international liquidity. In this regard, countries may be divided into four groups.

• Reserve currency countries: mainly the United States, Germany, and Japan, whose currencies are accepted as reserve assets and used as vehicles for international payments. These countries enjoy the privilege of not having to pay for their external deficits with goods and services.

• Countries with ample market access: mainly industrial countries that face a very elastic supply of liquidity at market interest rates. These countries can increase their foreign exchange reserves at a relatively low cost, either by purchasing reserve currencies with their national currency in the exchange market or by borrowing balances of reserve currencies in private capital markets or from other central banks.

• Countries with limited market access: mainly middle-income developing countries that face a steeply sloped supply curve of international liquidity. For this group of countries, holding borrowed reserves imposes a significant interest cost equal to the spread between the borrowing rate and the rate of return on reserve assets.

• Countries with no market access: mainly low-income developing countries that have to run current account surpluses in order to accumulate reserves. For this group of countries, the cost of acquiring reserves is the forgone consumption of investment implied in the generation of a current account surplus.

For the first two groups of countries, the current system works well. The supply of liquid funds that they can hold as reserves or use to finance payments deficits responds flexibly to changes in the demand for such funds. These countries can follow their chosen economic policies and maintain free trade and payments systems, since they face few risks derived from eventual liquidity constraints. The other two groups of countries, which comprise the vast majority of Fund members, are less fortunate.

The current arrangements for the provision and distribution of international liquidity give rise to a number of important shortcomings that, if overcome, would lead to a better performance of the world economy. Among these, the following may be considered:

• Seigniorage and asymmetry in access to liquidity.

• Insufficient financing of adjustment programs.

• A deflationary bias resulting from inadequate access to international liquidity.

• Volatility of capital flows.

Seigniorage and Asymmetry in Access to International Liquidity

Reserve currency countries with payments deficits have the freedom, at times very considerable, of settling them without undertaking adjustment policies. The acceptance of their currencies by the rest of the world allows them to finance their payments deficits simply through the issuance of currency. That is to say, unlike other countries, they do not have to pay for their trade imbalances through the sale of goods and services or by running down their international reserves. An undesirable feature of this arrangement has been the absorption of a substantial portion of the world’s net savings by the United States rather than by other less developed countries.

Although it is not possible to quantify the benefits of seigniorage that accrue to these countries, the simple sum of the holdings of their currencies by other central banks produces staggering amounts. At the end of 1995, total world foreign exchange holdings amounted to $1,320 billion.³ Out of this total, 79.5 percent corresponded to the three main reserve currencies: 58.1 percent to the U.S. dollar, 14.1 percent to the deutsche mark, and 7.3 percent to the Japanese yen.⁴ While these reserve holdings receive interest, the many billions of dollars and of other reserve currencies in circulation either as a store of wealth or as a means of payment in the former Soviet Union, Eastern Europe, Latin America, Asia, and Africa constitute huge transfers from poorer to richer countries in the form of interest-free loans.

The United States has been the largest beneficiary of these transfers, but over the last decade, as the share of the deutsche mark and the yen in international reserves has increased, Germany and Japan have also benefited from having their currencies become a major reserve asset and a vehicle for international payments.⁵

Other industrial countries have easy or large access to credit from international capital markets and are thus able to sustain large fiscal or external imbalances for long periods. Most developing countries, on the other hand, benefit neither from the creation of international liquidity and the seigniorage that benefits reserve currency countries nor from easy access to international financial markets and are therefore subject to a stricter discipline. Indeed, to the well-known asymmetry resulting from the burden of adjustment falling on deficit countries—as surplus countries have little pressure to correct their surplus—an additional asymmetry is added: that resulting from an unequal access to international financing and from an inequitable distribution of the benefits of international liquidity creation.

Insufficient Financing of Adjustment Programs

To attain the goals established in its Articles of Agreement, the Fund would make its general resources temporarily available to its members under adequate safeguards, “thus providing them with the opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.”⁶

In practice, however, an IMF-sponsored program does not necessarily lead to a successful adjustment. The evidence indicates that the availability and cost of financing have important consequences for the quality and effectiveness of countries’ programs for macroeconomic stabilization. A study of 266 IMF-funded programs during 1979–89 found that 52 percent of them failed in that they did not achieve their objectives and the countries were unable to disburse all resources available to them.⁷ The programs classified as successful by the authors received on average IMF support that financed 17 percent of their imports, whereas the programs that failed received only 6 percent. These results suggest that the probability of achieving a successful adjustment is enhanced when adequate financing is available. Conversely, when programs are provided with little financing they will be harsher and, thus, more prone to failure.

When financing is inadequate, the adjustment necessary to eliminate a balance of payments deficit may have to be extremely severe, with high costs in terms of national income and employment.⁸ Moreover, the conflict implied over the distributional effects of adjustment is exacerbated. Adjustment programs should take due account of the origins of an imbalance and provide the resources required to correct it over a reasonable period. A focus on aggregate demand management to correct external imbalances is adequate in many cases, but it is not necessarily appropriate when the disequilibria are of a structural nature. When this is so, the measures adopted to regulate aggregate demand only suppress or alleviate the symptoms of the imbalance but do not correct the underlying disequilibria. The recessionary adjustment associated with these programs implies high political and social costs. These costs, in turn, reduce the possibility of bringing the program to a successful conclusion.

Moreover, in order to strengthen the external payments position, adjustment programs generally imply a tightening of the fiscal stance even in countries in which public finances are already in balance. Often, to maintain fiscal balance in the face of a decline in activity requires that public investment in infrastructure, research and development, and other spending be reduced, postponed, or eliminated, and on many occasions health and education programs also suffer. This introduces additional costs because the correction of certain structural imbalances, requiring public expenditure, may be delayed, and the productive capacity of the economy over the medium and long terms impaired. However, because their effect is not always felt immediately, these costs are seldom considered.

The combination of lower economic activity and sharply higher interest rates that often accompanies the adjustment program has a disastrous impact on small and medium-sized businesses, causing loss of capital and employment with the consequent human distress. In addition, such a combination leads to an increase in nonperforming loans that may put financial institutions under strong pressure. The ensuing halt in the provision of new credits and in the rollover of outstanding loans adds to the disruptions in economic activity. Moreover, the fiscal cost of programs designed to support the financial sector to overcome these difficulties can be considerable and can extend over a prolonged period.

Recessionary programs lead to a waste of resources that ultimately produces considerable economic and social costs for the country in question and for the global economy as a whole. Therefore, it is in the interest of the international community to minimize these costs. To help economies adjust without undergoing the recessionary features of traditional programs, in October 1985 the IMF adopted the strategy of “growth-oriented adjustment,” a concept introduced by former U.S. Secretary of the Treasury James Baker.⁹

Clearly, adjustment programs consistent with economic growth require a much greater amount of financing than that provided under traditional programs. Indeed, the funds available should be consistent with the attainment of a minimum acceptable rate of economic growth. This target rate could, for instance, be the rate of growth of population or that of the labor force. In many cases even a program constructed to sustain zero growth would be an improvement on a program that implies a sharp decline in GDP.

Programs designed to promote adjustment with growth would have to go beyond the usual emphasis on aggregate demand management. In particular, such adjustment programs would not merely aim at the immediate restoration of equilibrium in a country’s external accounts, since this can always be attained through deflation. As a minimum they would be designed to sustain levels of investment required to preserve the country’s physical and human capital.

Unfortunately, since the quota increases have lagged far behind the financing needs of IMF member countries, the size of the Fund has declined from 7 percent of world trade in 1950 to less than 2 percent at present, which has sharply reduced the Fund’s ability to support adjustment with growth and in practice this concept has rarely been applied. To avoid the recurring difficulties associated with quota increases one could think of a Fund based entirely on SDRs as proposed by Polak (1979).

Deflationary Bias Resulting from Inadequate Access to International Liquidity

Under the present arrangements for the creation and distribution of international liquidity, access to it is concentrated in industrial countries and a few developing countries. As Table 1 shows, at the end of the first half of 1995, 22 industrial countries and 18 developing countries with access to international capital markets controlled 88.4 percent of international reserves. The rest of the world (more than 130 countries) have historically held a very low share of total world reserves in addition to having little access to private international financing. As a result, these countries are forced to “acquire more adequate reserves only through expensive borrowing in the market—in the few cases where markets would be prepared to lend—or compression of domestic demand and imports that would be inimical to their adjustment, reform, and growth efforts” (Camdessus, 1994b).

Table 1.

Shares in Total Reserves by Country Group¹

(In percent)

Source: International Monetary Fund, international Financial Statistics.

¹Figures are end-year except for 1995 (end-June).

²France, Germany, Japan, the United Kingdom, and the United States.

Table 1.

Shares in Total Reserves by Country Group¹

(In percent)

		1960	1970	1980	1990	1994	1995
Industrial countries		83.9	77.9	60.5	65.9	54.6	55.1
Reserve currency issuers2		57.2	43.7	35.0	33.1	29.1	30.4
	Of which:
	United States	32.3	15.5	6.1	8.9	6.2	6.8
Others		26.7	34.2	25.5	32.9	25.5	24.7
Developing countries		16.1	22.1	39.5	34.1	45.4	44.9
	18 countries with
	access to international
	capital markets	7.5	11.1	14.7	24.6	33.6	33.3
Oil-exporting countries		2.3	4.0	16.1	3.8	3.1	2.8
Remaining countries (over 130)		6.3	7.1	8.7	5.7	8.8	8.8

Source: International Monetary Fund, international Financial Statistics.

¹Figures are end-year except for 1995 (end-June).

²France, Germany, Japan, the United Kingdom, and the United States.

View Table

Table 1.

Shares in Total Reserves by Country Group¹

(In percent)

		1960	1970	1980	1990	1994	1995
Industrial countries		83.9	77.9	60.5	65.9	54.6	55.1
Reserve currency issuers2		57.2	43.7	35.0	33.1	29.1	30.4
	Of which:
	United States	32.3	15.5	6.1	8.9	6.2	6.8
Others		26.7	34.2	25.5	32.9	25.5	24.7
Developing countries		16.1	22.1	39.5	34.1	45.4	44.9
	18 countries with
	access to international
	capital markets	7.5	11.1	14.7	24.6	33.6	33.3
Oil-exporting countries		2.3	4.0	16.1	3.8	3.1	2.8
Remaining countries (over 130)		6.3	7.1	8.7	5.7	8.8	8.8

Source: International Monetary Fund, international Financial Statistics.

¹Figures are end-year except for 1995 (end-June).

²France, Germany, Japan, the United Kingdom, and the United States.

Developing economies with limited or no market access are not allowed to exploit their growth potential because of a lack of liquidity. Indeed, they are forced to rely almost exclusively on exports to satisfy their liquidity needs. Moreover, these countries do not have a diversified export base and thus are very vulnerable to swings in commodity prices. Their limited access to international liquidity forces them either to restrict aggregate demand or to constrain their imports to their limited supply of foreign exchange. But, of course, restricting imports implies restricting investment, which ultimately translates into low rates of economic growth. In this way, the lack of international liquidity introduces a deflationary bias into the performance of these countries and, through lower international trade, on that of the world economy. Clearly, this is inconsistent with the Fund’s Articles of Agreement.

Unfortunately, the current system does not ensure that the supply of liquidity and its distribution will respond to global needs. The IMF has not played the central role entrusted to it in the process of creating and distributing international liquidity. Despite acceptance of the objective of making the SDR the principal reserve asset, SDRs have declined as a proportion of world nongold reserves, from 5.8 percent at end-1975 to 2.3 percent at end-1995.

For a large number of countries insufficient liquidity requires the adoption of restrictive economic policies. Moreover, the effects are also felt by other countries and by the world economy as a whole. For instance, the liquidity shortage of the 1980s led to severe economic stagnation or decline in many of the Latin American economies. Some analysts have identified this as one of the factors behind the stagnation of demand growth for real U.S. exports between 1980 and late 1986, and thus, an important contributing factor to the deterioration of the U.S. external position during this period. On the other hand, the period of abundant liquidity during the early 1990s, which contributed to the resurgence of economic activity in many Latin American countries, made an important contribution to world export growth.

Volatility of Capital Flows

The process of financial innovation and the deregulation and liberalization of financial markets throughout the world have led to more integrated and globalized international capital markets. In addition, technological advances have increased the speed at which international financial transactions take place. As a result, the amount of capital traded in international markets has surged in recent years. For instance, in 1994 the value of international equity issues was almost 12 times larger than in 1990, while issues of bonds more than doubled in the same period.¹⁰” The volume of transactions in global foreign exchange markets has grown to over $1.2 trillion a day,¹¹ which is equivalent to the value of world trade in goods and services in a whole quarter.

By providing expanded opportunities to both borrowers and lenders, this process is clearly positive for the world economy. However, financial markets have shown a tendency toward great swings. Thus, there are periods of overshooting and, therefore, an unwarranted expansion of liquidity, followed by periods of undershooting or inadequate expansion or even contraction of liquidity for a country or group of countries. This poses new and difficult challenges for the financial authorities and the international community.

Massive capital inflows can complicate the conduct of economic policy because, regardless of the exchange regime, the currency tends to appreciate in real terms. Thus, financial authorities face the dilemma of sterilizing the incoming capital at the cost of holding reserves that yield a lower return than domestic instruments and inducing high interest rates, or allowing an excessive expansion of the monetary base that could translate into increased expenditure and inflationary pressures. Moreover, when portfolio investments account for an important portion of the funds, the risk of a sudden reversion of capital flows that could force the country to endure a painful adjustment is considerable.

Capital flows to emerging economies are often volatile for reasons that bear little relation to country risk:

• Exogenous and unanticipated changes in the financial conditions in the industrial countries can produce severe destabilizing effects in capital importing countries that are unrelated to their creditworthiness. Industrial countries generally formulate their economic policies based solely on domestic considerations, with little regard for the international repercussions of their actions. On several occasions, this has led to higher levels of real interest rates and exchange rate fluctuations that have increased the cost and diminished the availability of international financing to developing countries (Calvo, 1993).

• Capital inflows and commercial bank lending have been markedly pro-cyclical. Capital comes most readily when economic and business prospects are good, whereas capital flows tend to decline when the economy slows or when problems or uncertainties of any kind appear. Thus, capital markets themselves tend to undermine the creditworthiness of countries. As the Bank for International Settlements (1983, p. 130) stated some time ago:

  To put this view into perspective, it may be useful to imagine what would happen in a national context if during a recession banks were suddenly to cut off the flow of new credits to the corporate sector and to begin closing off existing short-term credit lines. The inevitable result would be a financial collapse which would threaten to engulf even soundly managed firms, including banks…. Such a financial collapse… would therefore not permit any easy inferences with respect to the quality of the pattern of bank lending and of corporate investment before the outbreak of the crisis, whereas the conclusion could safely be drawn that something had gone seriously wrong with the macro-economic management of the economy.

• Market behavior is often characterized by information asymmetries and contagion effects. Country risk analysis, which is far from perfect,¹² is often dominated by “herding” behavior. Recent episodes of financial market turbulence illustrate that a country might lose its creditworthiness overnight, leaving authorities little time to react. In some cases, the sudden loss of creditworthiness may be unjustified. Countries may face abrupt changes in the cost and availability of liquidity when unexpected events, such as major macroeconomic or financial shocks, trigger sudden shifts in market sentiment and create a strong need for additional reserves. As the market liquidity dries up, the country may face excessive adjustment costs. Moreover, there is a tendency to evaluate a country’s creditworthiness as a function of its regional location or stage of development rather than on its own merits. This is particularly true for developing countries. When a country in a certain group experiences payments difficulties, markets often tend to suspend new credits to all countries in the same region or with similar characteristics.

• In many cases, the process of restoring creditworthiness is unduly delayed. Investors hold back and wait for the recovery of the country in question, thus making it more protracted and uncertain. The official agencies regulating banks and extending official credit, as well as the rating agencies, also play an important role, but being cautious they may wait to see compliance with the program for a period of, say, a year or more before revising their appraisal.

The bandwagon effects, which abruptly reduce liquidity across the board, produce harmful effects for recipient countries and have a destabilizing impact on the international monetary system. In view of the considerable risk associated with the volatility of capital flows, recipient countries should not have to rely too heavily on these flows to satisfy their demand for reserves.

Summary of Shortcomings

Asymmetries in access to international liquidity aggravate the asymmetries in the adjustment process that cause deficit countries to bear an excessive share of its cost, while surplus countries have little pressure to correct their surplus and some of them enjoy the benefits of international seigniorage. Moreover, most adjustment programs appear to be underfinanced and consequently rely excessively on restrictive policies with adverse effects on output, employment, investment, and growth. This situation leads to a high proportion of program failures and is inconsistent with the objectives of the Fund as defined in Article I.

The current arrangements for the provision and distribution of international liquidity are inefficient and inequitable. The limited access of most developing countries to international reserves and financing has introduced a deflationary bias in the world economy. The volatility and uncertainties that countries face in satisfying their demand for reserves through the private markets impose heavy costs on them. Indeed, for developing nations, short-term capital inflows represent a mixed blessing as they pose difficult policy dilemmas that are aggravated by the risk of sudden outflows in response to factors beyond the control of their financial authorities.

The shortcomings of the current international monetary arrangements require increasing the availability of international liquidity and improving the way in which it is distributed to ameliorate the workings of the adjustment process and allow countries access to the liquidity needed to exploit their growth potential.

Proposed Alternative Arrangement

Proposal for Reserve Creation by the Fund

At present, SDRs are allocated in proportion to quotas as required under the Articles of Agreement. Thus, paradoxically, the main industrial countries, which have greater access to international liquidity, receive the bulk of the allocations as they command the largest quotas, whereas low-income countries, which have the greatest need to supplement their reserves, receive only a small proportion. On repeated occasions, there has been a call on industrial countries to redistribute their share of the SDRs to developing countries in order to improve the distribution of international liquidity among groups of countries. However, these proposals have not been implemented in spite of the support of France and Japan.¹⁵

A more efficient and more equitable arrangement would be to allocate SDRs following an agreed procedure in accordance with the reserve needs of individual countries, as determined by the Fund. For instance, the Fund could calculate the equilibrium long-run demand for reserves for each country. Reserve demand¹⁶ would be estimated according to the traditional explanatory variables, such as real output, the average propensity to import, and the variability of international transactions. Allocations would be made on a yearly basis to all eligible countries. The amount to be allocated to each country would be proportional to the calculated flow demand for reserves for the year. As under the current system, each country would decide if it accepted the amount allocated. Therefore, countries with market access could determine what part of their flow demand for reserves they desired to satisfy through SDR allocations and what part through other arrangements or through the market.

An alternative procedure for allocating SDRs in accordance with reserve needs could recognize that countries have different degrees of access to international capital markets and that, consequently, the cost of holding and acquiring reserves differs greatly among countries.¹⁷ A schedule for allocations could be agreed, in which the countries with market access would receive only a proportion of their flow demand, while those countries with limited or no market access would receive a higher proportion of their flow demand. Since market access and a country’s per capita GDP appear to be closely correlated, a schedule could be constructed by which the proportion of the reserve needs to be satisfied by SDR allocation is a function of per capita GDP. For instance, SDRs could be allocated according to a schedule as indicated in Table 2.

Table 2.

Illustrative Schedule for SDR Allocations

Table 2.

Illustrative Schedule for SDR Allocations

Per Capita GDP	Proportion of Calculated Reserve Need to Be Satisfied by SDR Allocation (Percent)
Under $1,000	90
$1,000–$3,000	70
$3,000–$6,000	50
$6,000–$9,000	30
$9,000–$12,000	20
Over $12,000	10

View Table

Table 2.

Illustrative Schedule for SDR Allocations

Per Capita GDP	Proportion of Calculated Reserve Need to Be Satisfied by SDR Allocation (Percent)
Under $1,000	90
$1,000–$3,000	70
$3,000–$6,000	50
$6,000–$9,000	30
$9,000–$12,000	20
Over $12,000	10

As can be seen in Table 2, under this (alternative) scheme, industrial countries that can readily obtain liquidity in the international markets receive only a small proportion of their reserve needs through an SDR allocation. Developing countries receive a greater proportion of their reserve needs through an allocation to compensate for their lack of access to international capital markets. No country receives the full amount of its reserve needs. Presumably, the credit-enhancing effects of the allocation would facilitate a country’s access to market sources of liquidity.

At the time of the first allocation, countries may face an initial deviation between the actual amount of their reserves and the calculated equilibrium long-run level. A formula could be devised to close the gap gradually between actual and desired stock of reserves.¹⁸ The speed of adjustment could take into account the situation of world liquidity as a whole. However, for simplicity, this aspect can be left open for further consideration.

SDR allocations could be made at the beginning of each calendar year. SDRs would be allocated to all those countries that were classified as eligible during the previous year. Alternatively, SDRs could be allocated to a country on the day of its Article IV consultation if it met certain eligibility requirements.

To be eligible to receive the regular allocations, a country would have to meet a predetermined set of criteria relating to fiscal balance, external position, etc., which would indicate that it is following sound policies. A set of criteria of the Maastricht type could be devised as benchmarks for eligibility. Those countries that met the criteria would automatically qualify for the allocation. Countries that did not meet the criteria could exceptionally qualify subject to an evaluation by the Fund of their policies and of the progress made toward reaching the benchmark criteria.

Every year, in the context of the Article IV consultation, the Fund staff would make an appraisal of the country’s economic policies based on the above-mentioned indicators, as well as other qualitative analysis. Through this process, the Executive Board, on the recommendation of the staff, would determine whether the country is eligible to receive its SDR allocation or would lay out the necessary steps for it to become eligible.¹⁹ This exercise would certainly give an important boost to the surveillance function of the IMF. Countries with limited or no market access would have the greatest incentive to become eligible, since the availability of liquidity coupled with the cost saving involved in obtaining liquidity at the SDR rate would produce the largest benefits for them. For industrial countries, SDR allocations would be an interesting alternative to borrowing in international markets, particularly during episodes of financial market turbulence and for countries that have a high debt-to-GDP ratio.

As under the current system, countries would pay charges for the net use of the SDRs allocated to them, while countries receiving the SDRs in exchange for their currency in excess of their cumulative allocations would be paid interest. The rate of charge for using the allocated SDRs would be somewhat higher than the interest rate paid on the excess over the SDRs allocated. This spread between the user rate and the holding rate would provide the Fund with an extra source of income that could be applied to constitute an administered account to be used if a country went into arrears in the SDR account. Once reserves had been built up to a sufficient level, the additional income could be used to subsidize IMF lending to the poorest countries under its concessional facility.

This system would not give rise to a resource transfer from net holders to net users of SDRs. As is well known, SDRs are costless to create. A country that spends the SDRs on real resources would enjoy a higher level of real resource use than otherwise, but this would be financed by the interest payments that are being made on the net use of SDRs. Since the interest rate on the use of SDRs would be a market rate, in effect, the Fund would be extending credit to the net users of SDRs and would be paying net holders of SDRs interest for their willingness to exchange their currency for SDRs. Countries that simply need to boost their reserves could do so at no cost, since they would just hold the allocated SDRs.

It can be argued that insofar as the interest rate on the net use of SDRs is below a member’s cost of borrowing in international capital markets, a resource transfer is taking place. In effect, this is correct. The resource gain from SDR allocations is derived from the Fund’s capacity to create international liquidity and of ensuring the payment of interest by those members that use the SDRs.

In essence, the role of the Fund would be to provide countries with adequate liquidity by enhancing the “creditworthiness” of those that do not have ready access to international capital markets. Thus, the IMF, acting as a financial intermediary owned by all the world’s governments, would fulfill a valuable risk-reducing role. Through its surveillance of a country’s economic policies, through its analysis of the world economy, and through its preferred creditor status, the IMF is in a position to minimize effectively the risk of default of countries receiving SDRs.

By supplying liquidity through allocations to countries following appropriate policies, the IMF would, in addition to supplying resources, endorse the policies followed. In so doing, it would contribute to reducing risk in financial markets. This should help reduce the tendency of the international capital market to overreact and to underlend to developing countries. An important part of the membership would benefit from a significant narrowing of interest rate margins, particularly countries with limited or no market access.

Experience under the current system has shown that countries at different times have willingly held SDRs in their reserves and been satisfied with the risk-adjusted return on their SDR holdings. This would continue to be so, since the credit risk would be shared by the entire IMF membership. Every country would be assured the payment of interest on their excess holdings of SDRs by the institution. Even under the current system, the SDR Department is required to pay interest to each holder of SDRs, whether or not sufficient amounts of SDRs are received in payment of charges, which virtually eliminates risk.

What incentives would countries have to maintain their SDR account in good standing? Would this mechanism give rise to moral hazard problems? Members place a high value on their relationship with the Fund. Even in the face of extreme balance of payments difficulties, members have endeavored to meet their obligations to the Fund and to the SDR Department. Under the proposed system, the nonfulfillment of their obligations in the SDR account would mean that the country is in arrears with the whole international community and thus ineligible to receive allocations. Therefore, tremendous pressure would be applied to the country involved. In effect, a country in arrears would become isolated from the world’s trade and payments system, lose access to financial and trade credit, and lose any aid flows from development finance institutions and, more generally, from the international financial community. Given the effects of reneging on its obligations, domestic public opinion would also demand that policymakers take the necessary steps to become current in their payments and that the country become eligible for future allocations. Thus, the moral hazard risks involved in the proposal would be minimal.

What Would Be the Benefits Under the Proposal?

• The direct benefits would accrue to member countries that have limited access to liquidity and a cost of acquiring reserves that is greater than the SDR interest rate. However, the main benefits are perhaps the indirect systemic benefits. The provision of adequate levels of international liquidity for all eligible countries would foster growth of trade and output, reduce the total credit risk in the global economic system, and provide real resource savings for countries collectively.

• The SDRs allocated would provide reserves at a lower cost than they can be acquired for through borrowing or current account adjustment. Therefore, the average cost of obtaining reserves would decrease for the majority of Fund members. Moreover, the greater availability of international liquidity to countries following sound macroeconomic policies could lead per se to an improvement of a country’s credit standing and hence to a reduction in their marginal cost of borrowing.

• If SDR allocations lead to a better balance of payments equilibrium and reduce the demand for foreign borrowing, they will reduce pressures on world savings and consequently on interest rates. The reduction in interest rates would stimulate investment and growth in the world economy. Major trading nations would benefit particularly.

• The greater availability of reserves would increase the probability of success of adjustment programs, particularly as countries could avoid excessive balance of payments adjustment for purposes of accumulating reserves. Therefore, the adjustment process would work better as it would be less recessive.

• The steady supply of SDRs would reduce the volatility of capital flows because inflows of capital to developing countries would not depend on the cyclical condition of the main industrial countries and would be less exposed to bandwagon and contagion effects. The increased stability in the flow of international trade and payments would allow capital-importing developing countries to pursue economic policies with a longer-term perspective.

Emergency Financing

Most countries that, despite fundamentally sound economic policies, experience short-term balance of payments or exchange market pressures do not have a readily available source of emergency financing.²⁰ The rapid development of financial markets and their increasing importance, together with the high degree of volatility of capital flows in recent years, has called for renewed attention to the role that the IMF can play in assisting members facing unwarranted pressures in their financial markets. By providing a formal “safety net” to countries following sound economic policies, appropriate emergency financing would improve the functioning of the international monetary system. In particular, it would prevent countries from resorting to capital controls or exchange restrictions when confronting short-term financial market disturbances. Against this background, the IMF could establish an emergency financing facility. Emergency financing would be provided through a Lombard-type facility for short periods and in exceptional circumstances. The operation of this facility could be subject to the following principles.

Access and Credit Limits. In principle, access to the IMF’s Lombard facility is given to all member countries’ central banks, that is, banks desiring access are granted a credit limit that they must fully and permanently collateralize. In case of an unexpected liquidity shortage, banks may borrow in part or in whole up to the credit limit, with maturities ranging from a minimum of one month, up to three months, renewable once. The Fund, in turn, could reserve the right to reduce a country’s credit limits at any time upon appropriate notice.

Collateral Eligibility and Rules. The Fund could accept eligible foreign and domestic securities, discountable bills, and gold as collateral for emergency loans, namely, (1) securities issued by public entities; and (2) highly rated bonds issued by recognized institutions provided they are traded in organized markets with regular publication of quotations. The securities would be subject to lending limits that vary between 40 percent and 80 percent of their market value, with foreign securities generally given a higher valuation than domestic securities.

Interest Rate. Emergency loans would be a source of exceptional financing from which central banks could draw on their own initiative. Loans could not remain outstanding for more than a few months in any 12-month period. The loans could serve as a safety valve for banks to tide over unforeseen liquidity shortages, particularly those arising from sudden capital movements. Credit would be granted at the SDR Lombard rate, which would be some 2 or 3 percentage points above the SDR interest rate in order to discourage their use.

Conclusions

The current international monetary system has important shortcomings: liquidity creation is governed by the monetary policies and payments disequilibria of the world’s major economies and capital flows by the vagaries of the markets. To the well-known asymmetry resulting from the burden of adjustment falling on deficit countries, a further asymmetry is added, resulting from the inequitable distribution of the benefits of international liquidity creation and from an unequal access to international financing. As developing countries are forced to limit their imports and levels of economic activity in order to avert payment crises, these asymmetries introduce a deflationary bias in the world economy. Moreover, despite widespread recognition of the benefits of adjustment with growth, financing for adjustment programs is generally insufficient to make it feasible.

In spite of having the instruments at its disposal, the central institution of the international monetary system, the IMF, has not been allowed “to supplement existing reserve assets in such a manner as to promote the attainment of its purposes and to avoid economic stagnation and deflation as well as excess demand and inflation in the world.”²¹

Clearly, to improve the functioning of the international monetary system, alternative arrangements, like the ones outlined in this paper, are needed. Such arrangements would ameliorate the workings of the adjustment process, reduce the risks associated with the volatility of capital markets, provide real resource savings for countries, and foster growth of world trade and output.

An enhanced spirit of international cooperation is required to render the international monetary system more efficient and equitable. It calls for the recognition by all IMF members of the needs and concerns of the less privileged members that are striving to pursue market-oriented policies and of the benefits that would accrue to the world economy.

A Focused SDR Allocation Muhammad Yaqub, Azizali Mohammed, and Iqbal Zaidi

A notable feature of the international monetary system as it has evolved since the SDR system was established by the First Amendment of the Fund’s Articles in 1969 is the rapid expansion of international capital markets. This has significantly enlarged the capacity of national authorities to acquire reserves through external borrowing, thereby making international liquidity a much broader, albeit more amorphous, concept than international reserves. Instead of relying exclusively on officially owned reserve assets for financing balance of payments deficits, a nonreserve currency country can tap additional resources by borrowing on private capital markets. This structural change makes it more difficult to derive meaningful criteria for assessing the long-term global need for reserve supplementation.

Recent discussions on the subject have focused on issues of access to international capital markets and on whether larger availability of “owned” reserves relative to “borrowed” reserves would improve the performance of the international liquidity system. This paper adopts this approach and presents a case for allocation of SDRs to those countries that would benefit most from them: developing and transition countries that either lack access to, or have to pay a significant risk premium when seeking to tap international markets as sovereign borrowers. In the ensuing discussion they are designated as nonaccess or low-access countries.

The proposal in this paper for a focused SDR allocation is quite distinct from the link proposals that would use the SDR system for transferring resources to developing countries. Unlike the link proposals in which the central element for the transfer of resources was the subsidy on the SDR interest rate, the case for the focused SDR allocation is made on the basis of a competitive SDR interest rate and how the SDR system helps to tackle the problem of maldistribution of access to international liquidity but without calling for a transfer of resources.¹ The focused SDR allocation proposal outlined here has some common elements with the proposal in Williamson (1994), which would have the IMF issue SDRs if a substantial block of countries were unable to borrow internationally at an interest rate close to the SDR interest rate. Williamson had suggested that all member countries would receive SDRs on the scale needed to satisfy the revealed reserve needs of the less creditworthy countries, but a focused SDR allocation would be confined to developing and transition economies with large reserve needs but with little or no access to market borrowing.

The first part of the paper argues the case for the constructive role that annual, relatively modest SDR allocations to these countries can play in strengthening the international liquidity system, by reducing the high cost of reserve supplementation faced by many countries and by promoting growth-oriented adjustment in countries that have no or low access. The second part provides illustrative orders of magnitude for annual allocations to such countries, which stay well within the bounds of the projected growth in the demand for international reserves, but might prove sufficient to help members maintain adequate reserve levels relative to their projected needs.

Maldistribution of Access to International Liquidity

Issues of “fairness” have featured prominently in historical debates on international liquidity. In the first stage, it was the “advantage” presumably enjoyed in the earlier postwar decades by the United States because of its reserve country status that enabled it to finance its balance of payments deficits by issuing foreign liabilities denominated in its own currency instead of having to draw down its foreign assets. This advantage has since been extended to a few other countries, notably Germany and Japan, as their currencies have been increasingly accepted—or permitted by their national authorities to be accepted—as reserve assets. The distinction of being a reserve currency has been further eroded by the growth of international capital markets that has enabled many more countries to borrow against their own IOUs, although for most such borrowers their lack of reserve currency status has meant that they could not denominate their obligations in their own currency but had to denominate them in one or another reserve currency. The liberalization of capital movements and the floating of major international currencies have allowed reserve currency countries to argue that they now enjoy no special advantage. Indeed, they might even be subject to a degree of competitive disadvantage because of the demand for their currencies to be held as reserve assets by other countries, and to higher volatility in the exchange markets for their currencies because of the actions of such holders in switching from one reserve currency to another. In any event, all such holdings by foreigners must be treated as voluntarily held at prevailing exchange and interest rates.

It has been argued by some observers that if countries accumulate reserves efficiently, the costs of acquiring reserves through different channels (for example, borrowing or current account adjustment) would be equated at the margin. As a result, there would not be a significant differential in the costs of acquiring reserves, whether those costs were to come from the external borrowing (if the country holds borrowed reserves) or in terms of the costs of domestic absorption forgone to generate reserves through current account improvements. This would suggest that the cost of external borrowing can be taken as an approximation of the cost of acquiring reserves in other ways. This would be true only if all countries were able to optimize at the margin, but many countries with no or low access to capital markets are not in a position to equate their external borrowing costs with current account adjustment costs because they face credit rationing in international capital markets. There are crucial differences between countries that have access to capital markets and those that do not, and, among the former, between sovereign borrowers that can acquire reserves in such markets at little differential cost, relative to the return on reserve assets, and those that pay a significant premium for such borrowings.

High Differential Cost Countries

We look first at the case of countries that do have access but pay high net carrying costs for borrowing. This cost can be measured by the difference between the lending rate and the market yield on reserve assets. For syndicated lending, the differential cost of borrowing is represented by the spread over LIBOR² or the U.S. prime rate. Although the interest rate fluctuates over the duration of the loan, the spread is usually fixed; it depends on the perceived risk associated with lending to a particular country as well as on the degree of liquidity in international capital markets. In the post-1982 “debt crisis” decade, syndicated lending to developing countries either ceased or remained confined to countries in East and Southeast Asia and a very few elsewhere that had somehow escaped the debt “contagion.” Even after its resumption in the early 1990s, syndicated lending has largely related to project finance for private enterprises or public sector entities borrowing for telecommunications and other infrastructure projects with identifiable returns.

An alternative measure is the differential cost in terms of fixed-interest sovereign bond obligations relative to the return on short-term U.S. Treasury paper. It is evident from available data that the net interest cost of holding reserves borrowed from private international markets is close to zero for most industrial countries and below 100 basis points for a very few others. The weighted cost of borrowing, as measured by the yield spread at launch for unenhanced bond issues by developing country sovereign borrowers, has varied between 200 and 300 basis points in the 1991–95 period, but with a spike to 450 points in the second quarter of 1994, presumably reflecting the aftermath of the Mexican crisis.³ Note that the yield spread measures the difference between the bond yield at issue for sovereign borrowers in developing and selected transition countries that have access to international capital markets and the prevailing yield for industrial country government bonds in the same currency and of comparable maturity.

When private markets are not willing to lend spontaneously to a country, a representative interest rate for the cost of external borrowing does not exist for that country. An alternative measure of the cost of holding reserves can be obtained by adjusting the U.S. Treasury bill rate, with the implicit yield evident in the international secondary market price for external debt.⁴ These implicit yield-to-maturity calculations for the cost of external borrowing indicate substantially higher costs for borrowed international reserves than those indicated by the interest rates on syndicated bank loans. Moreover, the implicit yield evident in the international secondary market price for external debt does not fully represent the cost of external borrowing for the developing country because it is derived under conditions of credit rationing.

Since the debt crisis of the early 1980s, commercial bank lending to countries with no or low access to capital markets has been concentrated in relatively secure, transactions-based businesses, such as trade and project financing, and banks have increasingly resorted to so-called structured finance (for example, collateralization) to shift the financing risk to borrowers. One technique to mitigate transfer and exchange rate risks has been to establish escrow accounts and to use future export receivables as collateral for commercial loans. However, these techniques have negative macroeconomic implications if pursued too vigorously or if risk-sharing attributes are skewed too heavily against the borrowing country. Furthermore, the earmarking of foreign exchange revenues for particular creditors reduces the country’s flexibility in responding to a balance of payments crisis. Finally, such contracts may have large upfront fees and they may set the price of receivables for countries with no or low access to capital markets at significantly below market levels (Collyns and others, 1993, p. 44). All this suggests that the interest rate on a commercial bank loan does not fully reflect the cost of holding reserves when developing countries borrow from international capital markets.

Beyond the substantial differentials, there is the problem that private capital markets have not been a reliable source of liquidity for most nonindustrial countries. Their access can be curtailed abruptly, often for reasons that have little to do with the policies pursued by individual countries but owing to “contagion” effects of developments elsewhere in the developing world or to “spillover” effects resulting from interest rate or other developments in the industrial countries.

Non-Access Countries

Even countries that have access at certain times are lumped together, in times of disturbance, with the much larger number of others that do not have access to portfolio capital, especially bond financing. Their reserve supplementation requirements can only be met by adjusting current account positions to expected capital inflows through reducing deficits or increasing surpluses. But such adjustments require reducing domestic absorption in order to expand net exports, typically achieved through compressing imports. Although it is difficult to quantify precisely the costs of forgone domestic absorption in order to generate any required current account change, several factors suggest why those costs should be even higher than the high differential costs that countries with access pay for their borrowed reserves.

The costs of import compression can be seen in the striking divergence between the average growth performance in the 1980s of the countries that encountered debt-servicing problems and others. These two groups had broadly similar growth records during 1968–80, which suggests that much of the sharp decline in output growth of the debt-distressed countries was related to the sharp curtailment of capital inflows. Moreover, since private capital flows had declined much more sharply than official capital flows, the average rate of economic growth of the market borrowers fell further between 1973–80 and 1981–87 than did the growth rate of official borrowers.

Many non-access or low-access countries are heavily dependent on imports of capital goods and intermediate products as inputs into production. External shocks that force countries to restrict imports of capital goods directly constrain investment. The strength of the link between import availability and output depends on the severity of the foreign exchange constraint, the relative openness of the economy, the degree of substitutability between imported inputs and domestic alternatives, and the extent to which a country’s policies permit shifts in relative prices to allocate available imports to uses with the highest opportunity costs.

Changes in the capacity to import will tend to have the largest impact on domestic output in the short run, when substitution possibilities are lowest. They will also have the largest impact on countries that do not possess a significant domestic capital goods industry and therefore have fewer possibilities of substitution between domestic and foreign goods in capital formation. When faced with severe foreign exchange constraints, the volume and speed of implementation of investment is slowed, at great cost to long-run economic performance. Marquez (1985) estimated the long-run elasticity of investment with respect to the purchasing power of exports (in terms of the imports of capital goods) at around 1.25 for the group of non-oil developing countries.⁵

Reducing Costs of Reserve Accumulation Through SDR Allocation

The costs of reserve accumulation for countries with no or low access range from those incurred through current account adjustment for countries lacking access, to the differential costs between borrowing rates and the rate of return on reserve assets for those with limited access. These costs have nevertheless to be incurred because of the benefits of holding reserves and the need to build them up in line with the growth of trade and other external financial transactions: the alternative of not doing so would be for the country to accept greater vulnerability to abrupt changes in the availability of external funding and having to undertake rapid import compression. However, these costs are saved if reserve supplementation takes place through the SDR system: the SDR system does not have a wedge between the interest cost of external borrowing and the return on reserve assets—the rate of charge levied against a country’s cumulative allocation is equal to the rate of interest paid on a country’s holding of SDRs.

It has been argued that the cost saving associated with SDR allocation is more apparent than real; it seemingly arises because the analysis understates a transfer of resources from countries with unimpeded market access to countries with no or low access (Corden, 1983). The transfer argument is based on the assumption that the wedge between lending rates and the return on reserve assets represents an entirely appropriate pricing of risk by markets and that the absence of the wedge in the SDR system therefore constitutes an implicit tax on creditors in the system. While recognizing the existence of the risk premium in private capital markets, it should be noted that many factors can give rise to a wedge between lending rates and returns on riskless assets, including market segmentation, cartel behavior by lenders or investors, and inefficiencies in financial market intermediation.⁶ In particular, in an international context, it is often very costly to obtain the necessary information to monitor closely a borrower’s investment activities, and this asymmetric information problem is made more serious by different national systems pertaining to accounting standards and disclosure requirements (Goldstein, Mathieson, and Lane, 1991, p. 24). The information problem increases the uncertainty that the financial market participants face and can lead lenders to demand a large risk premium from other than the primary borrowers. One of the conditions for the correct functioning of markets is perfect information about the goods and services exchanged. In situations where contracting parties have different information about some characteristics of the contract (for example, the quality of the product), there is “hidden information” and scope for adverse selection. On the other hand, when the possible outcomes of the contract depend on the actions of one of the contracting parties, which are not perfectly observable by the other party, there is “hidden action” and scope for moral hazard. Polak (1988, p. 180) has argued that “this is a case where the collectivity of members of the IMF, operating as a credit collective, can within certain limits provide capital more cheaply than the market could.” The resource gains of countries with relatively high differential costs of borrowed reserves are not at the expense of other participants.

The SDR system has been compared to the insurance principle of pooling risk and charging a premium based on the average risk of the pool. However, the adverse selection and moral hazard risks that insurance markets have to deal with are minimized in the SDR system. There is no adverse selection because almost all countries are members of the Fund; the moral hazard is minimized by the knowledge that a country that fails to meet its obligations would have to pay significant costs, not least of which would be exclusion from additional SDR allocations or even from access to conditional lending from the Fund.⁷

SDR Allocations and Conditional Lending

It has been argued that for countries in need of macroeconomic adjustment, an SDR allocation would be counterproductive because it would weaken their incentives to pursue appropriate policies. This is partly a question of the magnitude of allocations made on an annual basis and will be so argued in the following section. To overcome this argument against SDR allocations, several proposals have been made to link SDR allocations with adjustment programs supported by the use of Fund resources or to avoid excessive use of SDRs by reintroducing a reconstitution requirement (see, for example, Sengupta, 1987). In many respects, however, the issue of whether there are sufficient resources available for conditional lending is quite separate from the question of an SDR allocation. Questions regarding the adequacy of conditional lending should focus on such issues as whether the balance of payments deficits were being caused by permanent rather than by temporary shocks, whether certain policy measures that tended to promote efficiency in the economy had led in the first instance to a deterioration of the balance of payments and thus to a need for temporary financing, and the like. In contrast, questions on SDR allocations should focus on the costs of building up reserves through borrowing or import compression, and on how SDR allocations raise the proportion of owned reserves and thereby reduce the vulnerability to financial market disturbances of countries with no or low access to capital markets.

A more fundamental question is how inadequacy of “owned” reserves can undermine adjustment efforts. A country with adequate holdings of reserves and access to other sources of international liquidity can sustain a smoother adjustment process because it can finance its way out of temporary external shocks. However, where there is inadequate liquidity, even temporary shocks will force a country off its adjustment path. This will apply even to those with past access to markets if such shocks result in curtailing access at a time when it is most needed. Even when access is not impeded, the cost of such funding can be volatile for marginal borrowers, depending on conditions and policies of major industrial countries. SDR allocations, being “owned” reserves, can promote steadiness of adjustment policies in the face of market volatility.

Focusing SDR Allocations on Countries That Would Benefit

The case for SDR allocations on an unconditional basis has been argued in terms of their benefit for countries without access or with limited access to international capital markets. The basic flaw in the current arrangements is that they mandate allocations for a majority of members that no longer have a need for them, being able to borrow reserves at little net cost. It is clearly suboptimal to have to create SDRs in a multiple of the amounts actually required for those that would really benefit from them. It furnishes a false argument about the inflationary effects of SDR allocation, an argument less credible in current circumstances than when first advanced. It sets up opposition in some industrial countries about the undermining of the appropriations authority of parliamentary bodies.

The purpose of the illustrative exercise is to indicate that the magnitude of such allocations would indeed be rather modest. One could start with countries judged as eligible for concessional funding by the international financial institutions. Most countries eligible only for IDA assistance or eligible for the enhanced structural adjustment facility (ESAF) would be included in any list of countries with no or low access, even if most of them have access to trade credits or export credits, guaranteed by official insuring agencies in the exporting country. Nor should the presence of an occasional corporate borrower or a marginal investor such as an emerging market mutual fund be considered as making them market borrowers. It is the typical lack of access to fixedinterest bond markets or even adjustable-rate syndicated markets as sovereign borrowers that defines their status as countries with no or low access.

However, this status should not define eligibility for SDR allocations under the scheme proposed here. The first criterion of exclusion could be based on ratings assigned by major rating agencies, such as Moody’s and Standard and Poor’s Investor Services. Countries receiving an investment grade from one or the other rating agency would be considered as having the capacity to borrow net reserves at low cost: on this basis, two of the largest quota holders in the developing world—China and India—would be excluded. Countries not rated by either agency would qualify for inclusion as would those given a “noninvestment grade.”

The second criterion for exclusion could be reserve levels relative to imports in a preceding (say) three-year period. The threshold for exclusion might be a level of reserves exceeding (say) 50 percent of imports in a recent period, on the reasoning that countries already holding reserves equivalent to six months worth of imports did not need additional support through SDR allocations. On the basis of this criterion as well, China and India would be excluded. In addition, it may be noted that when the structural adjustment facility (SAF) and ESAF were set up, China and India had agreed not to make use of resources from these facilities.

Assuming that SDR allocations could continue to use Fund quotas as the key for distribution, one has a group with aggregate quotas of SDR 23.2 billion on the basis of applying the two exclusion criteria (Table 1). This represents an outer limit, however, as the scheme allows countries to opt out if they do not wish to be included. This would apply to such countries as Mexico that might consider their current loss of investment grade to be a temporary aberration or to some of the oil producers in the Gulf and in the Caribbean that were not rated because of lack of interest on their part. Some other countries might decide not to participate in a focused SDR allocation if they apprehend that inclusion in the list of those eligible might be seen as negative from a market-access point of view. Finally, countries could be given the right of opting in during any year that they felt the need to exercise their eligibility.

Table 1.

Fund Quotas of Countries Eligible for Focused SDR Allocations

(In billions of SDRs)

Table 1.

Fund Quotas of Countries Eligible for Focused SDR Allocations

(In billions of SDRs)

Country Group	Total Quotas of Group	After Excluding Countries with Reserves Exceeding 50 Percent of Imports, 1992–4	Number of Countries
I. ESAF/IDA-Eligible Countries	15.624	7.487	78
II. Countries not included above and not rated or rated below investment grade	24.852	15.710	66
Summation of rows I and II	40.476	23.197	144

View Table

Table 1.

Fund Quotas of Countries Eligible for Focused SDR Allocations

(In billions of SDRs)

Country Group	Total Quotas of Group	After Excluding Countries with Reserves Exceeding 50 Percent of Imports, 1992–4	Number of Countries
I. ESAF/IDA-Eligible Countries	15.624	7.487	78
II. Countries not included above and not rated or rated below investment grade	24.852	15.710	66
Summation of rows I and II	40.476	23.197	144

The second issue is the quantum of allocation to be made on an annual basis. Here there are two constraints to be considered: the first is the risk that the size of allocations undermines the Fund’s conditionality and the second is whether creditors of the SDR system might begin to consider their holdings to involve an implicit tax. It has been argued earlier that from the perspective of countries with no or low access, an unconditional SDR allocation has the potentiality of strengthening the adjustment effort of countries.⁸ However, some have argued otherwise and it is essential that the magnitude of allocations be set at a level so as not to be seen as interfering with the normal conditionality of Fund programs. Assume that annual allocations would not exceed (say) 20 percent of quota. Comparing this percentage with access limits for programs under the Fund’s ESAF and extended Fund facility currently in place, it would be hard to believe that countries would put the availability of such larger sums at risk; this is especially true for a number of countries whose access to bilateral assistance and debt relief—and even to other multilateral funding—is contingent upon their meeting performance criteria or benchmarks under the Fund’s conditional facilities.

There remains the question of whether creditors of the SDR system would be prepared to absorb annual allocations in the range of SDR 4.0–4.5 billion a year (assuming 20 percent of quota as the outer limit for annual allocation) without regard to acceptance limits currently established by the Articles. Three considerations have to be kept in mind. First, only when members receiving allocations actually use them would creditors in the SDR system come into the picture. Given the reserve supplementation function that is primary to the allocation process, one should expect most recipients to continue to hold their SDRs voluntarily; this would be especially true of countries that have obtained Fund assistance under its conditional facilities and must cover the exchange risk of repayment in SDRs from their reserve currency assets. Second, the two exclusion criteria and the opting out procedures earlier outlined would reduce the list of countries over time as their reserves build up, their access to private capital markets opens up, and their credit ratings improve; this would be particularly applicable to major transition countries like Russia and some of the countries in Central and Eastern Europe. Finally, there does appear to be a growing willingness on the part of a certain number of countries to acquire and hold SDRs in excess of their allocations; this is indicated by the virtual redundancy of the designation mechanism after 1987.⁹ The need to be concerned about acceptance constraints could be further reduced if the usability of SDRs were enhanced by enabling the major international commercial banks to qualify as “other holders” of SDRs, thereby making a market beyond the official circuits to which the SDR mechanism is presently confined.

Concluding Remarks

In making the case for an unconditional allocation of SDRs, this paper has focused on the point that if there are no SDR allocations, the countries with no or low access will have to incur substantial costs to acquire the additional reserves they need. Reserves that have been obtained by borrowing on international capital markets impose a significant net interest cost for countries below investment grade. Reserves that have been obtained through the compression of domestic demand and net imports impose a significant cost in terms of forgone consumption or investment. These costs exceed the true economic opportunity cost to the world of creating additional reserves through an SDR allocation. SDR allocations reduce the cost of holding reserves for countries with no or low access because SDRs have no net carrying cost if they are held as a part of reserves (that is, SDR charges are offset by SDR interest payments). Circumstances that would force some countries to use their SDR allocations temporarily would indicate a judgment that the net interest costs of such use are lower than the costs incurred by negative alternatives such as accumulating arrears, compressing imports, or taking other adjustment measures.

This paper has emphasized that SDR allocations improve the distribution of international liquidity and promote growth-oriented adjustment programs. The ability of a country to persevere in implementing an adjustment program in the face of shocks that adversely affect its balance of payments position depends on the terms and conditions under which it can obtain international liquidity. An analysis of the trends in net borrowing from private creditors by countries with no or low access shows that the volume as well as the price of private foreign capital inflows have varied considerably over time. However, when there is inadequate liquidity, even temporary external shocks can force the country to modify its adjustment policies. This choice may not be desirable when there is a strong adjustment program in place, because a sharp change in policies can needlessly depress investment spending and thereby limit growth.

The proposal put forward for a focused unconditional SDR allocation suggests that SDRs should be allocated to countries that have relatively large reserve needs but have little or no access to international capital markets. Since the proposal focuses on a group of countries that have a small share of Fund quotas, it helps to reduce any potential inflationary impact of SDR allocations. It is recognized that the Fund has no authority to make selective allocations, but, given the impasse concerning SDR allocations, it is time to look for ways beyond the current Articles of Agreement. It is hoped that the present proposal will be seen as a midway point between the divergent positions adopted by the great majority of the Fund membership on the one hand, and a few major creditor countries of the Fund on the other, and thus help to move the SDR discussion forward.

General Discussion

Horst Siebert, referring to the interconnection between international reserves, monetary policy, and exchange rate policy, raised the question of seigniorage, which, he suggested, was the reward for price stability. He asked Ariel Buira if newly industrializing countries could solve the seigniorage problem by setting up a currency board arrangement. The currency board would establish a currency’s reputation, and if the supporting monetary policy remained credible, the newly stable currency could draw seigniorage away from the other major currencies.

Ariel Buira responded that stability alone would not be sufficient to earn seigniorage from international usage of a currency. A large economy was also required, because such seigniorage could only be earned by a currency that was internationally accepted as a means of payment. However stable Guatemala may be, for example—and it was extremely stable for forty to fifty years—the quetzal was never quoted in international financial markets.

John Williamson noted that a currency board enabled the authorities to recapture some of the seigniorage derived from domestic money creation, but it was not a relevant mechanism for capturing the seigniorage that comes from international reserve creation. A currency board arrangement did not establish an independent currency that countries would want to hold as international reserves.

Helmut Hesse distinguished between two wholly separate problems that had been cited in discussing the roles of the IMF and the SDR in the international monetary system, and argued that these two problems should not be mixed together. If a country that lacked creditworthiness and, hence, access to private financial markets, experienced a liquidity crisis, it should receive help from the IMF—but that help should be in the form of conditional lending. However, if the issue was one of resource redistribution, then in his view the IMF had no role to play. Hesse said he favored the development of the IMF in the direction of the central bank of a financially integrated world—and central banks had nothing to do with redistribution.

Peter Kenen asked Iqbal Zaidi and his coauthors how their proposal differed from the “link” proposals of the 1960s and 1970s, under which SDRs would be allocated to low-income countries with weak reserve positions, and the industrial countries would in effect earn reserves through sales of goods and services to the developing world.

Kenen also said he had found some internal inconsistencies or tensions between the two parts of Buira’s proposal. An emergency financing facility operating as a safety net implied a certain short-term elasticity to the SDR on a fairly large scale. If, for example, the action taken by the IMF and others in response to the Mexican peso crisis had been effected through an emergency facility, it would have generated a large increase in the stock of SDRs, at least in the very short run. Yet if, at the same time, the IMF moved toward being a fully SDR-based institution, as the second part of Buira’s proposal suggested, then some member countries might need reassurance that the IMF’s ability to create credit and to provide balance of payments financing would not be unlimited in the aggregate.

Iqbal Zaidi said the link proposals of the 1960s and 1970s had been intended to “kill two birds with one stone.” On the one hand, SDR allocations to all member countries would solve the liquidity and deflation problems embodied in the Triffin dilemma. On the other hand, since the SDR interest rate was below market interest rates at that time, the allocation would act as an aid mechanism, providing a real transfer of resources to reserves-starved developing countries whose severe budgetary constraints effectively stifled growth and adjustment. Today, however, the SDR interest rate was no longer concessional, and selective allocations would not embody an aid mechanism or involve a transfer of real resources to poor countries since creditors to the SDR system receive market interest rates. Rather, selective allocations would be a means for these countries to acquire reserves without incurring the costs of import compression, and for the IMF to distribute liquidity more efficiently than the market.

Buira, responding to Kenen’s question, said the emergency financing mechanism he had proposed provided for repayment in the short term. But even a large loan that could not be repaid in the very short term—such as the $40 billion extended to Mexico—would not have a significant effect on the total stock of international reserves, which amounted to about $1.4 trillion. Moreover, it was unlikely that the major industrial countries would avail themselves of this facility, since the interest rates on the SDRs would be higher than the cost of borrowing in the market.

Jacques Polak mentioned another important distinction between selective allocations and the link proposal. Under the link proposal, an estimate would be made of the total amount of reserves that ought to be created, and this total amount would be fed into the system through the developing countries. Under the selective allocation proposal, only the reserve needs of the small number of eligible countries would be estimated and allocated directly to them.

Polak said both the paper by Buira and that by Yaqub, Mohammed, and Zaidi espoused the principle that since there was no longer a point in across-the-board allocations to all IMF members, allocations should go only to the countries that would benefit from them. He noted with approval that the Yaqub-Mohammed-Zaidi paper further emphasized that allocations should add up to a small proportion of quotas. This principle, he said, reconciled the conflict inherent in the IMF’s being in the business of dispensing both conditional and unconditional credit—a conflict that could only be resolved by making the availability of unconditional credit much smaller than conditional credit in terms of quota.

Polak concluded by asking Zaidi and his coauthors which countries they had in mind to receive the selective allocations and how long eligibility would last.

Azizali Mohammed said that countries that could borrow in capital markets or could borrow government bond paper at a very low cost would not be eligible to receive an SDR allocation under their proposal. Based on these exclusion criteria, two categories of countries would be eligible: many, but not all, of the countries eligible for ESAF (the IMF’s concessional financing facility) or IDA (International Development Association, the World Bank’s concessional lending facility), would receive allocations; and all of the transition economies.

In response to Polak’s question about how long a country could continue to receive allocations, Mohammed referred to two provisions that would limit eligibility. First, under an “opting out” provision, a country with a temporary liquidity problem that prevented it from borrowing at low cost from the market could nevertheless decline to accept an SDR allocation because of the possibility that the market might treat as negative the country’s willingness to accept an allocation.

Second, the scheme would not give rise to an ever-increasing injection of SDRs into the system, because a country that was able to accumulate reserves equivalent to 50 percent of annual imports over a three-year period would no longer be eligible for additional allocations. Thus, after an initial period of allocations large enough to build up and sustain a country’s reserves, the size of allocations would gradually come to equal only the amount consistent with the rate of growth of imports. As countries became able to accumulate reserves, improve their credit ratings, and obtain investment-grade ratings in capital markets that permitted them to borrow at low net cost, they would lose their eligibility for SDR allocations.

Michael Mussa said it was not clear from either the Buira proposal or the Yaqub-Mohammed-Zaidi proposal who would be issuing the SDRs and against whom the holders of those SDRs would have a claim. One option (suggested by Polak) would be for the IMF to issue SDRs, and for recipients of SDRs to hold claims against the IMF, including all of its assets. The IMF’s General Resources Account would thus assume the liability, thereby providing a guarantee of creditworthiness on the SDRs that had been issued. Another option would be to rely on the designation mechanism under the present system, which permitted a member holding SDRs to use its SDRs to obtain an equivalent amount of currency from another designated member. Pursuit of this option, however, presented a problem, since the allocations would go only to countries in need of reserves and would thus be heavily unbalanced. Because none of the creditor countries would be in the system, there would be no official agency to pick up the credit side of the transaction.

Buira noted that in his proposal the IMF assumed the liability and acted as a broker. In the event of market failure—for example, when a country suffered from an unjustified loss of creditworthiness—the IMF could enhance creditworthiness by attaching conditions to SDR allocations, such as the requirement that countries meet certain policy criteria to qualify. The moral hazard risk was minimal because a country that defaulted on its obligations would be in arrears to the entire international financial community and would face virtual “civil death.”

Mohammed indicated that he and his coauthors were also inclined to have the IMF assume the liability, as in the systems suggested by Polak.