My comments on the SDR will be in three parts: the origin of the SDR, the nature of the SDR, and the future of the SDR.
My comments on the SDR will be in three parts: the origin of the SDR, the nature of the SDR, and the future of the SDR.
The Origin of the SDR
The SDR originated in the late 1960s during the period of fixed exchange rates. Monetary authorities held reserves that could be used to maintain the external value of their currencies in foreign exchange markets. Thus, for example, if the United Kingdom held U.S. dollars in its reserves, and if the demand for the pound sterling were to fall and therefore the value of the pound were also to fall in the market, the U.K. authorities could use their dollars to buy pounds and thus stop the decline in the value of the pound. Similarly, if the demand for pounds should be strong and the value of the pound should start to rise, the U.K. authorities could sell pounds for dollars. In that case, the amount of dollars in their reserves would be increased.
As a matter of practice, countries held their official reserves mainly in the form of gold and U.S. dollars. Their “working reserves” were dollars. This was natural because the dollar was the principal form of money used in international transactions. Of course, some countries held pounds or deutsche mark in their reserves because it was more appropriate for them given their trading patterns.
The formal link between U.S. dollar reserves and gold reserves was maintained by the willingness of the U.S. authorities to exchange gold and dollars at a fixed rate. This system, by which dollars linked to gold served as reserves, was known as the gold exchange standard.
The U.S. dollar was a good reserve asset because it satisfied the principal requirements of a good money: It served as a unit of account, as a store of value, and as a medium of exchange. As a unit of account, it was a useful measure of value because it was widely used in the world, both in official and in commercial transactions. As a store of value, it was as good as any other asset because of its link to gold. As a medium of exchange, it was outstanding because (1) it was generally acceptable by other monetary authorities; (2) it was usable in dealings with commercial banks in the foreign exchange markets; and (3) the large capital market of the United States was available to serve the credit needs of official entities seeking to borrow reserves.
But problems arose with the gold exchange standard. In a growing world economy, there is a growing demand for reserves. But two contradictions, or asymmetries, in the system impaired its ability to supply reserves:
First, even if the supply of dollars could be expanded, the gold backing for the U.S. dollar could not be expanded, or at least not smoothly. So, as more dollars were backed by the same gold stock, or even a smaller gold stock in the United States, the convertibility of the dollar became doubtful, and the U.S. dollar itself became less acceptable.
Second, the asymmetry of the system whereby one country could draw resources from the rest of the world through a current account deficit and pay for them by issuing reserves seemed inequitable and therefore unacceptable.
Therefore, the search began for a resolution of the contradictions. Over the years, several approaches have been considered and tried, and the quest still continues.
One idea that was considered and rejected was that, if the physical supply of gold could not be controlled—being subject to the uncertainties of new gold discoveries and to changes in industrial demands—perhaps the value of gold in the system could be increased by raising the price of gold. There were many reasons for rejecting this idea. An important reason was that, because of the distribution of gold holdings, the gains from the increase in the gold price would be inequitably distributed.
Another idea for resolving the contradictions that has proved to be ineffective was the idea that, if the supply of reserves could not grow to meet the demand, perhaps the demand itself could be reduced. It was thought by some that, if the world moved to floating exchange rates, monetary authorities would no longer need or wish to hold reserves. But our experience with the floating rate system has now proved that this view was incorrect. Even with floating exchange rates, monetary authorities still wish to hold reserves in growing amounts.
Creating a new reserve asset was yet another idea. It was felt that, if a new reserve asset were created by a group of countries, and best of all by the Fund itself, it would resolve the inequity implied by the then existing system that concentrated the reserve-creating power mainly in the United States. And so the idea of a new reserve asset, issued by the Fund and serving as a supplement to gold, was born. The Articles of Agreement of the Fund were amended, with effect from July 28, 1969, to authorize the Fund to allocate SDRs to its members, in proportion to their quotas, in order “to meet the need, as and when it arises, for a supplement to existing reserve assets.”
The Articles provide that decisions to allocate SDRs shall be taken for so-called basic periods of up to five years in duration. In the first basic period 1970–72, SDR 9.3 billion was allocated; in the second basic period 1973–77, no SDRs were allocated; and in the third basic period 1978-81, SDR 12.0 billion was allocated. No decision to allocate SDRs in the fourth basic period has yet been taken, and SDR 21.3 billion is outstanding.
It was hoped that the SDR might become the principal reserve asset of the system. Manifestly, it has not yet done so, although one day it may. But the world has been exploring other resolutions of the gold exchange standard contradictions while continuing to experiment with the SDR.
Another approach to the contradictions was to abandon the formal link to gold. In 1971, the United States withdrew its undertaking to meet official demands to convert U.S. dollars to gold. This action resolved one of the contradictions but not the other, namely, the asymmetry in the distribution of reserve-issuing power.
For a while, the world responded to this asymmetry by diversifying its reserve holdings among currencies. The deutsche mark and, to a lesser extent, the Japanese yen emerged as new reserve currencies. The pound sterling has been a reserve currency for a long time. The Europeans created a new composite unit—the European Currency Unit—which, for members of the European Monetary System, serves as one form of reserve holding.
During this period when countries were diversifying their reserves among currencies, much consideration was given in the Fund to the setting up of a substitution account to permit monetary authorities to substitute SDRs for some of their dollar holdings in reserves. Several forms of a substitution account have been considered. The most recent version envisaged that a new account would be opened in the Fund, on one or more specific occasions, to enable members on a prescribed basis to exchange dollars for a form of SDRs. However, interest in the substitution account declined before it could be established—for the same reason that interest in diversifying reserve holdings among currencies declined; namely, the value of the U.S. dollar began once again to appreciate in exchange markets, and therefore the monetary authorities were more content to hold it.
The SDR has not yet become the principal reserve asset. The world continues to need reserves, and it continues to experiment with its reserve system.
Many changes have been made in the characteristics of the SDR since it first came into existence. Instead of listing these changes in detail, I will state the main characteristics of the SDR as it exists today.
The Nature of the SDR
The SDR consists of a credit established in the books of the Special Drawing Rights Department of the Fund in favor of the member. As mentioned above, these credits are created on the occasion of an allocation and are provided in proportion to members’ quotas.
The SDR is now defined in terms of a basket, or collection, of the five major currencies of the world: the U.S. dollar, the deutsche mark, the Japanese yen, the French franc, and the pound sterling. The amount of each currency in the basket is fixed for extended periods. The value of the SDR at any time in terms of a given currency may be calculated by using the exchange rates of the constituent currencies against the dollar and the rate of the given currency against the dollar.
Interest is earned and paid on SDRs at a rate calculated quarterly as the weighted average of interest rates on short-term domestic obligations in the five countries whose currencies are included in the SDR basket. The Fund pays interest at this rate to holders of SDRs, and members pay interest to the Fund at this rate on their allocations of SDRs. Thus, a member that holds SDRs in amounts equal to its allocation receives exactly as much interest as it pays. Accordingly, it has, in effect, a costless line of credit. When a member uses its SDRs by exchanging them for currency or settling obligations to the Fund, it draws on this line of credit, and it makes a net interest payment to the Fund on the amount of SDRs used.
Let us look at the present-day SDR in terms of its characteristics as money:
(1) As a unit of account it is easily used, and to date its major use has been as a unit of account. The Fund’s accounts are kept exclusively in SDRs. Some 15 international organizations use the SDR as their unit of account or as the basis of their accounting unit. The SDR is also used as a standard of value in a significant number of international conventions such as the Universal Postal Union and the Convention on the Carriage of Goods by Sea. Sixteen members of the Fund peg their exchange rates to the SDR.
(2) As a store of value, the performance of the SDR rests on the performance of its constituent currencies. If the constituent currencies lose their purchasing power at high or uneven rates, the SDR will be less attractive as a store of value than the superior performers among national currencies.
(3) As a medium of exchange, the SDR has as yet only a limited role. This is partly because of the constraints that the Fund puts on the use of the SDR accounts held with it. It is also partly due to the fact that the use of SDR-denominated assets and liabilities by institutions other than the Fund and the monetary authorities that deal with the Fund has so far developed only to a very limited extent.
What uses can be made of SDRs in exchange? They may be used in transactions with the Fund, with other members of the Fund, and with so-called prescribed holders. In transactions with the Fund, members may use SDRs in most instances and must use them in some cases. Charges for the use of Fund resources must be paid in SDRs, and normally a portion of a quota subscription must also be paid in SDRs. Repayment of debts and other transfers to the Fund may be made in SDRs. The Fund, for its part, may make transfers to members in SDRs.
Members of the Fund may use SDRs in a wide variety of official transactions with other members. Thus, they may use SDRs to obtain currency, to extend loans, to make donations, to settle financial obligations, and in other ways.
Members may receive SDRs from other members either by agreement or by designation. In the case of designation, the Fund designates members having an adequately strong international financial position to receive SDRs. Designated members are required to accept SDRs until their holdings reach a figure three times their cumulative allocations.
Prescribed holders are 13 international financial institutions, such as the World Bank and the Bank for International Settlements, and some development banks, which have been authorized by the Fund to deal in SDRs with members of the Fund and institutions having prescribed holder status.
It should be noted that the SDRs allocated by the Fund may only be used in official transactions and then with some restrictions. They cannot be used by official entities in transactions with nonofficial entities such as commercial banks. In this respect, they are quite unlike U.S. dollars.
It is possible for commercial banks and others to issue liabilities and acquire assets denominated in a basket of currencies equivalent to the SDR. To a very limited extent this has happened. It would, in my opinion, have to happen on a very considerable scale if the SDR is to become the principal reserve asset of the system.
The Future of the SDR
The future of the SDR depends partly on actions that the Fund itself may take and partly on the nature of the evolution of the international monetary system at large.
Actions that the Fund may take are of three kinds:
(1) It may improve further some of the technical characteristics of the SDR and of the facilities for its use provided by the Fund. In the last decade, a great many improvements in the original design of the SDR have been made. These have greatly enhanced its acceptability in competition with other official reserve assets and have improved its usability. There is a limited range of further improvements that can be suggested, and the staff of the Fund is studying them and will probably put some of them to the Executive Board for consideration from time to time. These past and prospective improvements are discussed in some detail in Mr. Familton’s paper.
(2) The Fund may resume allocations of SDRs as conditions warrant.
(3) The third kind of action the Fund could take would involve an enlargement of the functions of the SDR in the Fund.
I am now going to refer to some ideas that do not have the approval of the Fund but are simply suggestions that have been put forward in various quarters for discussion.
The Fund could make adjustments in the manner in which it performs its functions so as to accord a larger role to the SDR and a smaller role to currencies in its activities. The advantage that might be derived in making these adjustments would lie in promoting wider use of the SDR as an international asset.
I offer one example simply by way of illustration. The Fund now finances its loans to members mainly by the use of currencies given to the Fund in payment of quota subscriptions. One could, in principle, dispense with this use of currencies. One could retain the concept of the quota to determine voting power and the limits to each member’s access to Fund resources. But instead of a member drawing currencies from the Fund when it uses the Fund’s facilities, it might very well draw SDRs created specifically for the purpose. These SDRs would then be used in transactions with other members to obtain currencies needed.
As the system evolves, if privately issued SDRs become more commonly used, the Fund might usefully provide accounts through which national central banks could settle SDR-denominated obligations with each other. This technique of settlement would be similar to the arrangements provided by central banks for settlements among commercial banks. This is a Fund service which is by no means required today, but which the Fund might consider offering if it were needed in the future.
The ultimate role of the SDR in the system lies beyond the power of the Fund to determine in any direct or deliberate way. It depends on the evolution of the international monetary system itself. A more integrated system will evolve in a more stable world. A more integrated system will minimize the differences among national currencies and the values of national currencies. In these circumstances, it will be more natural to use composite currency units. When such units are more commonly used in international commerce, they will more naturally be held as official reserves. It is in that kind of integrated world economy that the SDR will come into its own as the principal reserve asset.
This paper, a brief introduction to the SDR, was delivered by Mr. Hood as Mr. R.J. Familton, the scheduled speaker on the subject of SDRs, was unable to attend the colloquium. Mr. Familton’s paper was distributed to the participants and appears in this volume beginning on page 146.