SDR Allocations and the Present Articles of Agreement Montek Singh Ahluwalia¹

The purpose of this paper is to consider whether an SDR allocation can be justified in current circumstances on the basis of the Articles of Agreement of the Fund as they stand at present. The issue has assumed special importance because of the impasse on SDR allocations that surfaced at the Interim Committee meeting in Madrid in 1994 and that continues unresolved to this day. The Fund management, backed by the technical expertise of the Fund staff, has come to the conclusion that a modest SDR allocation of SDR 36 billion over a five-year period is needed. A majority of Fund members, including all developing countries, the countries in transition, and some industrial countries have supported this conclusion. However, some of the major industrial countries remain unconvinced.

The persistence of this impasse raises suspicions that it reflects not just technical differences on interpretation of the relevant Articles but more fundamental differences about the future role of the SDR in the international monetary system as it has evolved. The first section of this paper discusses the Articles of Agreement as they presently stand, identifying the key ambiguities that leave room for disagreement. The following section examines past practice with SDR allocations to see if it provides a guide for the future. The final section examines the case for an SDR allocation in present circumstances.

The Relevant Articles and Their Ambiguities

The Articles relevant for deciding on an SDR allocation are Article XVIII, Section 1(a), and Article XXII. These are reproduced below, with key phrases italicized for emphasis.

Article XVIII, Section 1(a)

In all its decisions with respect to the allocation and cancellation of special drawing rights the Fund shall seek to meet the long-term global need, as and when it arises, to supplement existing reserve assets in such manner as will promote the attainment of its purposes and will avoid economic stagnation and deflation as well as excess demand and inflation in the world.

Article XXII

In addition to the obligations assumed with respect to special drawing rights under other articles of this Agreement, each participant undertakes to collaborate with the Fund and with other participants in order to facilitate the effective functioning of the Special Drawing Rights Department and the proper use of special drawing rights in accordance with this Agreement and with the objective of making the special drawing right the principal reserve asset in the international monetary system.

Article XVIII, Section 1(a), indicates, in general terms, the conditions under which an SDR allocation should be made. Broadly, it is necessary to demonstrate a long-term global need to supplement reserves, and this must be done in a manner that avoids both stagnation and inflation. Some aspects of these criteria have been further clarified in the Fund Board discussions, but others remain imprecise:

• (1) The reference to “long-term” needs implies that SDR creation is not meant to respond to cyclical shortages but rather to shortages over a longer period of, say, five years. An implication of this interpretation is that SDR creation need not be in response to a current or immediate need, but in anticipation of a need expected to arise in future.

• (2) No specific method has been prescribed to quantify the extent to which reserve assets need to be supplemented by allocations of SDRs. Implicitly, quantification of the supplement required depends upon the ability to (a) quantify the demand for reserves, or the optimal level of reserves and (b) quantify the available supply of reserves from various sources. In this context it becomes relevant to consider whether the SDR is an instrument of last resort, to fill the residual gap, if any, after all other sources of supply of reserves are exhausted, or whether it is designed to fill the gap between the demand for reserves and the optimal supply from various sources. Reference to optimality in relation to the supply from various sources is important because it may be possible to achieve any given level of reserves by relying heavily on borrowed reserves, but this may not always be optimal. Even when a reserve buildup through borrowed reserves is feasible, achieving the same objective through an SDR allocation may improve the composition or quality of reserves. Recognizing this aspect, it has been clarified in past discussions that there may be a case for an SDR allocation even in situations where the required level of reserves could be obtained from other sources.

• (3) The interpretation of the term “global need” also requires some clarification. SDR allocations are clearly not to be triggered in response to the needs of individual countries, or even a small group of countries. But does global need have to be defined in terms of a universal shortage of reserves or can it be defined to cover situations of reserve shortages affecting a sufficiently large number of members? This is obviously a crucial issue in assessing the case for an SDR allocation in current circumstances.

• (4) Whatever the case for SDR allocations on grounds of reserve shortages, the decision to allocate SDRs must keep in mind both the need to avoid economic stagnation and deflation as well as the need to avoid inflation. In practice, the concern with avoiding inflation has been repeatedly emphasized by industrial countries.

Article XXII is a general exhortation to members to cooperate with the Fund on matters relating to SDRs with the objective of making the SDR “the principal reserve asset” in the system. Developing countries have consistently argued that this objective provides an umbrella justification for periodic allocations of SDRs. The principal reserve asset objective need not be defined crudely in terms of some target share for SDRs as a proportion of world reserves, but equally, it surely implies that cumulative SDR allocations must at least bear some reasonable relationship to aggregate reserves if it is to be taken seriously at all. In practice, this creates a presumption in favor of a steady process of SDR allocation, in line with growing levels of world reserves, though perhaps varying contracyclically with inflationary pressures.

Implications of Past Practice

Ambiguities in the letter of the law (in this case the Articles) are normally resolved by reference to case law, which establishes how the law has been interpreted in the past. Unfortunately, the case law available to us in the matter of SDR allocation is very limited as there have been only two occasions in the past when there was agreement on SDR allocations.

The first allocation of SDRs took place shortly after they were created in 1969, when a total of SDR 9.5 billion was allocated over the three-year period 1970-72. However, the circumstances prevailing then were wholly different from those prevailing today. The par value system was in existence and the dominant concern about managing the international monetary system was the fear of global reserve shortages arising out of the twin problems of a limited supply of gold and the inherent instability of the only alternative, which was to rely upon growth in dollar reserves as a source of liquidity. The SDR, with a constant gold value, glamorously described as “paper gold,” was expected to provide a viable source of reserve expansion, free of the instability associated with expanding dollar reserves based on perpetual U.S. deficits.

This original role for the SDR was overtaken by events almost immediately after the first allocation. The par value system collapsed, and the world shifted to floating exchange rates and multiple currency reserves. The emergence of international capital markets created the possibility of building reserves by borrowing in private capital markets, thus eliminating the link between dollar reserve accumulations and U.S. deficits. These structural changes in the international monetary system necessarily implied that the rationale for future SDR allocations would have to be very different. There was in fact an explosion in world reserves in the 1970s and a significant acceleration in world inflation. These developments were bound to discourage fresh allocations, and there was no agreement on SDR allocations until 1979.

The second allocation of SDRs took place shortly after the Second Amendment to the Fund Articles in 1978, and this allocation has much more relevance to the current situation. Floating exchange rates had become a reality and international capital markets provided many countries with access to reserves if needed. Although the original role envisaged for the SDR had evaporated, the process of reforming the international monetary system, which had been under way since 1973, clearly envisaged a continuing need for the SDR. One of the elements in the reform proposal, later incorporated in the Second Amendment to the Articles in the form of Article XXII and Article VIII, Section 7, was to make the SDR the principal reserve asset in the international monetary system. The precise meaning of this objective was never made clear, and the perceptions of industrial countries and developing countries were very different. Industrial countries were probably concerned primarily with the need to avoid the exchange rate instability that might result from any large scale movement out of dollar reserves and felt that a substitution of dollar reserves by SDRs may have a stabilizing effect. Developing countries had long argued that what they needed was not so much reserves as a steady flow of resources to finance development, and in this context various proposals were advanced for a link between SDR creation and development financing. The idea of a link in all its many variants was firmly rejected by the industrial countries, but they did concede that one of the objects of reform of the monetary system should be to increase the flow of resources to the developing countries. There was no commitment that this increased flow should be through SDR allocations, and it could be argued that the reference was to other flows, including the flow of conditional resources.

Despite these developments, agreement on an SDR allocation was not easily achieved. The major industrial countries opposed an allocation on the grounds that there was no demonstrable global need for reserves. The following extract from de Vries (1985, Vol. II, p. 879), describing the views of Executive Directors on SDR allocations in 1978, bears an uncanny resemblance to the current debate.

The main question relevant to SDR allocations in this situation was whether the global need for reserves should continue to be met mainly through increases in holdings of reserve currencies or whether part of the need for additional reserves could and should be met by allocations of SDRs.

The Executive Directors could not agree on the answer. Some argued that no problem arose with respect to world liquidity if increases in reserves continued to take the form of national currencies. No allocations of SDRs were necessary. Others took the position that any further increases in world liquidity through the Fund should be conditional, that is, in the form of larger Fund quotas rather than of SDR allocations. These Executive Directors argued that, were members to receive more SDRs, some might postpone needed balance of payments adjustment. Recourse to conditional liquidity, that is, to use of the Fund’s resources, would require them to take measures to reduce their balance of payments deficits.

In the end the Managing Director was able to achieve a consensus on SDR allocations as part of a “package” involving not just SDRs but also a 50 percent increase in Fund quotas, which would provide the basis for expanded conditional liquidity from the Fund, an increase in the SDR interest rate, and the use of SDRs to pay for part of the increase in subscriptions resulting from the quota increase. An important feature of the 1978 decision was that it recognized that a decision to allocate SDRs can be justified even though most countries are in a position to achieve the desired levels of reserves from international financial markets. The Managing Director’s proposal also included specific reference to the objective of making the SDR the principal reserve asset as a relevant consideration supporting an allocation. A total allocation of SDR 12 billion was made in three installments in the last three years of the third basic period, 1978-81.

On the face of it, the 1978 decision was taken in circumstances not too dissimilar from the current situation and could be a relevant precedent for the future. However, it appears to have been an isolated event. No further SDR allocations were made in the 1980s despite considerable evidence of reserve stringency in many developing countries. These were the debt crisis years, and most developing countries experienced severe balance of payments difficulties, with serious import compression in many cases. Demands for fresh allocations of SDRs were regularly repeated in successive communiqués of the Group of Twenty-Four but no agreement could be reached. Fund staff papers in this period appeared to endorse the need for an allocation. The ratio of cumulative allocations of SDRs to aggregate nongold world reserves declined from 6.5 percent in 1982 to an estimated 2.5 percent at the end of 1995. This is much below the level of 3.8 percent prevailing in 1978, when the second allocation was made. Like the “dog that didn’t bark,” the failure to reach agreement on SDR allocations in the 1980s has become part of the case law that indicates how member countries interpreted the Articles in this period.

There are two possible explanations for the prolonged SDR drought in the 1980s. First, this was the period of structural adjustment following the debt crisis in Latin America and sub-Saharan Africa, and the dominant perception of the international community was that the solution to the problems facing these countries lay in the implementation of strong structural adjustment policies, supported by provision of conditional rather than unconditional resources. Second, it was also a period when industrial country policies focused heavily on controlling inflation. Inflation was much lower in the 1980s than in the 1970s, but perhaps not low enough for fears of inflation to abate.

In retrospect, we know that although adjustment and economic reforms were undoubtedly needed, many structural adjustment programs, implemented under strict conditionality in the 1980s, were much less successful than expected. This is not to deny the importance of conditional resources provided from the various facilities of the Fund. Such resources undoubtedly have a major role to play in facilitating adjustment in developing countries, but this does not warrant a conclusion that all resources must necessarily be conditional. If limited expansion in unconditional resources is justified on merit, it should not be jeopardized by an insistence upon conditional resources.

The resistance to an SDR allocation because of the concern with control of inflation is more understandable. Most industrial countries had experienced a sharp increase in inflation in the 1970s, which continued into the 1980s. The rate of inflation declined steadily in the first half of the 1980s from 12.4 percent in 1980 to 4.4 percent in 1985. It fell to 2.6 percent in 1986, but then edged up again to 5 percent by 1990. The experience thereafter was, however, quite different, and the rate of inflation has been below 3 percent since 1992. In retrospect, it is difficult to believe that a modest allocation any time after the mid-1980s would have had any significant effect on inflation.

Part of the reason for lack of agreement on an SDR allocation after 1981 probably lies in the change that took place over this period in the attitude of industrial countries toward the Fund, In 1978, there was a much more universal recognition among industrial countries of the role of the Fund in ensuring international monetary stability. The collapse of the Bretton Woods system was still relatively recent, and confidence in the new system had yet to evolve. In 1978, the financing role of the Fund was not viewed, as it is today, as relevant only for developing countries. Both the United Kingdom and Italy had entered into stand-by arrangements with the Fund in 1977, and in 1978 the United States drew on its reserve tranche as part of the Carter Administration’s package for stabilizing the dollar. In the 1980s, the perceptions of industrial countries about the role of the Fund changed considerably. Although problems of coordination of macroeconomic policy among major countries remained serious, the Fund was not always seen as having an active role to play in this process. Increasingly, the Fund was seen as relevant primarily to handle problems of developing countries and, more recently, those of the countries in transition. This inevitably led to a reduction in the bargaining power of developing countries and to a greater focus on conditionality attached to Fund resources.

The Case for an SDR Allocation Today

We now turn to an assessment of the case for an SDR allocation in present circumstances. The arguments for an allocation are well known and have been recently summarized in Buira and Marino (1995). They are reviewed below with an attempt to identify those elements of the argument on which there is disagreement and consider how they stand up against established practice in interpreting the Articles of Agreement.

One element of the argument that is generally agreed is that there will be a substantial growth in demand for reserves, in proportion to world trade or only slightly more slowly. Buira and Marino (1995) estimate an increased demand for reserves of about SDR 400 billion over the next five years, whereas Mussa in his paper for this seminar puts the figure a little lower, at SDR 350 billion. These estimates are broadly accepted, allowing for the usual margins of error. The contentious issue is whether it is necessary to allocate SDRs to meet any portion of this increase. Opponents of SDR allocations argue that there will be no difficulty in obtaining the necessary increase in reserves from the financial markets. Experience suggests that this may well be so for total reserves. Between the end of 1981 and 1994—a period in which no fresh SDRs were allocated, the ratio of nongold reserves to merchandise imports for all countries increased from 19 percent to 27 percent.

Special Needs of Some Countries

The case for a fresh SDR allocation therefore rests not on the expected shortfalls in the potential supply of aggregate reserves but rather on the distribution of global reserves in the absence of SDR allocations. The apparent adequacy of aggregate reserves at present hides considerable variation across countries, with many countries suffering from inadequate reserves. About a third of the developing countries and more than half of the transition countries had reserves below 8 weeks of imports in 1992. If the more conventional criterion of 12 weeks of imports is used to identify reserve shortages, almost two thirds of developing countries and three fourths of transition countries have inadequate reserves.

These countries do not have adequate access to world capital markets and cannot rely on that source to build up reserves at a reasonable cost. They would either have to borrow at high cost to build reserves or more likely could only rebuild reserves to adequate levels by adjusting their current account positions. In practice, this often means following contractionary policies aimed at import compression, which have often led to a prolonged slowdown in growth. This imposes a high cost not only on these economies but to some extent also on the rest of the world, if we take into account the collective impact of such policies in many developing countries. These costs have to be compared with the cost of a fresh SDR allocation, which is demonstrably quite low.

Industrial countries have consistently opposed allocation of SDRs to meet the reserve needs of a group of countries on the grounds that the Articles refer to allocations to remedy global reserve shortages and not shortages affecting groups of countries. Opponents of an allocation recognize that some countries do not have access to financial markets, but they argue that is so because of deficiencies in those countries’ policies. The denial of credit by financial markets to such countries is therefore a desirable market signal emanating from well-functioning markets, which serves to encourage these countries to adopt necessary adjustment measures. Provision of low-cost liquidity on an automatic basis through SDR creation in these circumstances is seen as a distortion of the market mechanism, weakening market signals and encouraging postponement of adjustment. An extension of this argument is that if some developing countries are indeed facing resource shortages, these resources are best provided through one of the conditional facilities of the Fund and not through the allocation of SDRs.

Some of these arguments are clearly based on misperceptions. One relates to the issue of whether SDR allocations imply an unjustifiable subsidy. As pointed out in Coats and others (1990), an SDR allocation implies a net grant element in favor of net users of SDRs only if the interest rate paid to SDR holders is not competitive with other reserve assets, or if the rate of charge on allocations does not include an adequate risk premium. As it is generally conceded that SDR interest rates are competitive with the return available on other comparable reserve assets, there is no subsidy on this account. For the rate of charge, it is certainly true that most net users of SDRs would pay significantly higher rates when borrowing in private markets, reflecting the market perception of risk premium. However, this does not necessarily imply that the rate of charge on the SDR is subsidized. It can be argued that net users of SDRs are highly unlikely to default on net interest payments on their SDR use, because they value their status as members cooperating with the Fund. If members do indeed display a greater commitment to meet their obligations arising out of SDR use, there is no case for charging a risk premium. The lower cost of reserves obtained from an SDR allocation is therefore not at the expense of other participants in the system. It reflects a genuine efficiency gain to the world economy arising out of the status of the Fund as an international institution and the greater compliance that it can evoke from members.

The concern that SDR allocations will weaken market signals also does not stand up to detailed scrutiny. As Polak (1988) pointed out, there is no reason to begrudge countries an SDR allocation that is otherwise justified simply because it might loosen the tight grip of conditionality. There are other favorable outcomes that might have the same effect, and we do not react to them in the same way. In any case, the impact on the incentive to adjust depends upon the size of the allocation. An allocation of SDR 36 billion over a five-year period amounts to only 25 percent of Fund quotas, or an average increase of 5 percent of quota a year. Additional availability of unconditional resources of this size is unlikely to have any impact on the willingness of countries to undertake adjustment, as adjustment-based programs can make available much larger amounts of Fund resources, up to 110 percent of quota.

To some extent the recent proposal of the Group of Seven countries for a special allocation on grounds of equity in favor of the countries in transition itself implies that additional allocation of SDRs justifiable on merits need not be seen as a weakening of the adjustment programs. The same argument can be extended also to a general allocation.

The Quality of Reserves

Even if we accept that many developing countries may be able to build up adequate reserves by accessing international financial markets, a case can be made for SDR allocations on the grounds of the quality of reserves. Any given stock of reserves acquired through a greater reliance on borrowing in international financial markets implies a greater vulnerability to changes in market conditions. Borrowed reserves have to be refinanced periodically, and unexpected changes in international capital market conditions may lead to a sudden withdrawal of such finance. SDR holdings are also borrowed reserves in one sense, but since the allocations are permanent (except in the event of cancellation—which is theoretically possible), they are always available to the holder as an assured line of credit, irrespective of changes in financial market conditions. A reserve composition with a greater SDR component therefore represents a superior quality of reserves, providing a greater assurance of stability in the system.

It is important to emphasize that this concern with the quality of reserves is not merely theoretical. It is of immediate practical importance in a world in which international financial markets, though enormously important and capable of great flexibility, are also far from perfect. The experience with commercial bank lending to developing countries in the 1970s and 1980s amply demonstrated the extent of that imperfection as the markets first lent imprudently to developing countries, and then withdrew excessively, necessitating extensive official action to avoid destabilizing shocks and to restore reasonable flows of funds to these countries. The same problem surfaced again in the aftermath of the Mexican cnsis, when there were widespread fears of “contagion effects” on other developing countries. The fact that these effects were quickly contained only testifies to the effectiveness with which the Mexican crisis was handled, but it does not detract from the assessment of the underlying vulnerability of the system. This vulnerability would be reduced if a larger portion of the world’s reserves were to come from SDR creation.

The concern with the quality of reserves can only be heightened by the changes that have taken place in the relative size of resources available from official and bilateral credit arrangements that constitute a safety net for the system. The relatively lower level of reserves held by industrial countries compared with developing countries is partly a reflection of the availability of a more extensive safety net available to these countries. These arrangements include resources potentially available through the Fund, including the General Arrangements to Borrow and SDRs, the U.S. Federal Reserve’s reciprocal currency arrangements, and the European Monetary System’s support facilities. It is estimated that these resources aggregated SDR 110.7 billion in 1979, or about 40.5 percent of world nongold reserves. By 1990 the absolute size had increased to SDR 186.2 billion, but as a proportion of total reserves they had declined to 29.1 percent.

The Impact on Inflation

Avoidance of inflation is explicitly mentioned in the Articles of Agreement as a relevant consideration in deciding on SDR allocations. Any argument in favor of SDR allocations must therefore address this issue. The nature of the linkage between SDR allocations and inflation is well known. An allocation by itself cannot lead to any inflationary pressure unless it leads to additional spending by some of the recipients. It is possible to argue in principle that an SDR allocation leads to no additional spending, and the entire amount of the allocation is simply added to reserves. But this is unlikely to happen. In practice, one should expect that an SDR allocation will lead to some increase in total reserves, some switching from other borrowed reserves to SDRs, and some increase in spending. If SDRs are used to finance additional expenditure by some recipient countries, this leads to an accumulation of reserves in the country in which they are spent, and this reserve buildup could be associated with an increase in money supply and therefore in prices in that country. This, however, depends upon whether the monetary authorities sterilize the reserve accumulation by open market operations.

As the monetary authorities in the major industrial countries normally sterilize the impact of any reserve accumulation, it is reasonable to conclude that a modest SDR allocation would not lead to any inflationary pressure, especially when we consider the quantitative magnitudes involved. For example, a general allocation of SDR 36 billion over five years involves an average annual allocation of a little over SDR 7 billion a year. Of this amount, only about SDR 2.7 billion would accrue to developing countries and countries in transition. If we assume that half of this is spent, the additional expenditure would be only about SDR 1.4 billion a year, which would be reflected in an increase of this magnitude in reserves of different industrial countries. The monetary authorities of industrial countries should have no difficulty in sterilizing accretions to their reserves of this size.

The fear of inflation following a modest allocation of SDRs therefore appears grossly exaggerated. This conclusion is only reinforced by the fact that inflation in the industrial countries has been at a historic low of about 2.5 percent a year for the past three years, and there are no signs that it is about to accelerate. Even if we concede that the fear of inflation, which held back allocations of SDRs in the 1980s, had some justification in terms of inflation expectations not having been reduced, no such problem exists today.

The SDR as Principal Reserve Asset

Finally, we need to consider the case for an SDR allocation from the point of view of the objective of making the SDR the principal reserve asset of the system. Developing countries fully recognize that this objective should not be interpreted to mean continuing large allocations irrespective of the availability of liquidity from other sources. However, it must also be recognized that in the absence of an SDR allocation, with the expected growth in total reserves, the ratio of SDRs to nongold reserves will fall to less than 2 percent at the end of five years. This proportion was 3.8 percent when the second allocation was made, which raised the percentage to 6.5 percent in 1981. An allocation of SDR 36 billion would raise the proportion only to about 5 percent.

Industrial countries clearly believe, even if they do not always assert, that the objective of making the SDR the principal reserve asset of the system has lost its relevance. The earlier fears of exchange rate instability consequent upon a flight from dollar reserves have abated as the system of multiple currency reserves appears to have functioned reasonably well. However, industrial countries would not go so far as to say that the SDR has outlived its usefulness and should be abolished. There is probably a consensus that the SDR is an extremely useful instrument that can provide a multilaterally controlled safety net that could be quickly deployed in the event of an unforeseen strain on the financial system. Even this minimal concession is relevant in considering the case for an SDR allocation. The effectiveness of the SDR in being able to deal with unforeseen emergency situations depends upon the instrument not atrophying through lack of use. A fresh allocation at this stage, 15 years after the last allocation, is surely warranted for this reason alone.

Conclusion

We can now pull together the main strands of the argument developed in this paper. The Articles of Agreement can at best provide only broad directions about the considerations that must guide the allocation of SDRs. Interpretation of the Articles has to evolve over time, taking into account precedents and the current consensus about the world economic situation.

It is clear that the world economy has changed substantially from when the SDR was first invented, and even from the time of the Second Amendment. The rapid growth of international financial markets has created a situation in which industrial countries, and even many developing countries, can meet their growing demand for reserves from the market—at least in normal times. However, this is not true for a very large number of countries for whom the markets are either closed or too expensive. Nor can we say with any confidence that market perceptions of the creditworthiness of developing countries, which are reflected in the risk premiums that they have to pay, are especially accurate. For all their sophistication, international financial markets remain vulnerable to herd instincts and contagion effects, which can introduce a high degree of volatility into the access of individual developing countries.

In this situation a case can be made for periodic general allocations of SDRs as envisaged in the Articles, especially when inflationary pressure in the world economy is low. The definition of global need should be interpreted, as it was in 1978, with sufficient flexibility to allow a modest to moderate allocation of SDRs from time to time. Although such an allocation may seem to be needed primarily by a group of countries, a general allocation also improves the quality of aggregate reserves for the world as a whole. It also helps to maintain the SDR, if not as a principal reserve asset, then at least as a credible element in the international monetary system, with the potential to provide a much larger safety net if needed in an emergency.

No Future for the SDR

Horst Siebert ¹

Michael Mussa has presented an inspiring paper making a case for moderate SDR allocations and providing an informative historical background. However, I come to a different conclusion.

SDRs were introduced (as Mussa points out) to solve the credibility problem that arose in the 1960s with central bank reserves in U.S. dollars increasing and with U.S. gold reserves declining: the so-called Triffin dilemma. Thus, SDRs were a solution to a specific problem. But the initial raison d’être of SDR allocations no longer exists. Do we still need them?

SDRs can be interpreted as a form of “paper gold” or “monetary gold,” that is, as an artificial international reserve. In a broad interpretation, they provide, free of charge, a credit option, or more precisely, an option to obtain foreign currency. When the option is used, a (privileged) interest rate is applied. The allocation of SDRs can thus be understood as a credit (or currency option) arrangement for international reserves where the credit option (currency option) is guaranteed by an international agreement that also specifies the conditions under which a credit (or currency) can be obtained. Starting from this interpretation, I want to make the following points.

It is true that we observe an increase in international reserves of central banks (in absolute terms) with an expansion in world trade. But such an increase in international reserves (documented by an import elasticity of reserves of, say, 0.85) is not a sufficient reason for SDR allocations, as Mussa himself points out. The ratio of reserve holdings to merchandise imports has remained surprisingly stable for the world as a whole and for industrial countries in the last 45 years, while increasing for the developing countries. This stability in the ratio of reserves to imports can be taken as an indication that the system has been capable of generating the reserves it needs.

Our specific question is not whether we need more reserves per unit of imports—which we apparently did not in the past—but whether we need more SDRs. In order to make the case for an additional SDR allocation, one would have to show (according to the First Amendment) “a long-term global need … to supplement existing reserve assets.”

Mussa does not succeed in proving that there is a global need: more SDRs are not a necessary condition for an increase in world trade. The share of SDRs in international (nongold) reserves declined from a maximum value of about 8 percent in 1972 to 2.3 percent at the end of 1995, but world trade has expanded substantially. Obviously, international trade was not restricted by the limited volume of SDRs. It is difficult to see how an expansion of SDRs would bring about an additional expansion of world trade.

Besides the problem of proving a “need,” the additional issue in Mussa’s paper is one of transforming the need into a quantitative yardstick of how much of the need should be supplied by SDRs, since SDRs should play only a supplementary role. Accepting the institutional arrangements of SDRs for the sake of the argument, economists should be able to have a basic model in which the optimal quantity of SDRs is determined by comparing the marginal costs and the marginal benefits of one additional unit of SDR, similar to the manner in which the optimal demand for international reserves can be specified. If marginal benefits exceed marginal costs, more SDRs should be provided. To address this issue requires a clear definition of the maximization problem; an important question is which agent’s preference function should be maximized. As we do not have such a model, the economic case for SDR allocation is weak.

Mussa’s answer is that some additional SDRs cannot hurt, especially as costs to net users are low. From a methodological point of view such a pragmatic answer is not convincing. It is also not convincing that the share of SDRs in international reserves given in a specific year in the past should remain constant. Why should it?

Thus, we do not have a clear quantitative yardstick with which to determine what the need is and which part of the need should be provided by SDRs.

The core question is not, of course, whether it is optimal to provide one additional unit of SDR within the given institutional arrangement but whether the system of SDRs contains institutional details that are not optimal and whether the institutional arrangement as such is meaningful.

Suboptimal institutional details distort behavior; such institutional details may be corrected, however, without jeopardizing the approach itself. Interest rates are such a case. Mussa mentions that the SDR interest rate is a market rate representing a weighted average of five countries whose currencies are in the SDR basket. This is only part of the picture. First, the SDR rate is a short-term rate, whereas SDR credits have increasingly changed into long-term credits. Since the reconstitution requirement was dropped in 1981, allocated SDRs can de facto be used for an unlimited time. Second, the SDR interest rate does not contain a risk premium, for instance, a premium for country risk. Consequently, distortions are implied (Schroder, 1990, p. 71). The short-term rate induces countries that have a deficit in their balance of payments (or that are threatened by depreciation of their currency) to use SDRs instead of paying the higher interest rate in the world capital market for long-term credits. This applies especially to countries facing a high-risk premium in the world capital market. For countries with a surplus, it is not attractive to hold SDRs relative to other reserve assets because of their relatively low short-term rates; in a way the IMF rules make it possible to force such countries to buy and hold SDRs by being designated.

To reduce these distortions, long-term rates should be used for SDR allocations and credits. This practice would bring the interest rates on SDR allocations partly into line with the market rates (with the exception of country risk premiums) and, as a consequence, partly establish the right incentives for deficit countries as well as for surplus countries. Thus, a reintroduction of the reconstitution requirement would not be quite so necessary.

A much more important issue is to what extent incentives of countries with deficits are systematically distorted by SDRs. This issue cannot be addressed adequately by suggesting (as in Mussa’s paper) that the scale of magnitude is negligible. Institutional arrangements have to be judged according to the criterion of incentive effects rather than according to the criterion of scale or of magnitude.

Apparently, there are incentive effects of SDRs. Consider two different types of countries, one willing to follow a stabilization policy with respect to its price level, for instance, by implementing a currency board approach to monetary and exchange rate policy, and the other being more reluctant to comply with stabilization constraints that allow a higher inflation rate and a depreciation of its currency. For this more inflation-minded country, a generous provision of SDRs is indeed not an incentive to steer national monetary and fiscal policies in such a way as to obtain stability.

The allocation of SDRs per se does not affect the monetary base of a country, as SDRs represent an asset as well as a position on the liability side of the balance sheet of the central bank (in a bookkeeping sense). The allocation of SDRs is therefore an enlargement of the balance sheet of the central bank. When SDRs are used to augment international reserves and when they only change the composition of the asset side of the central bank balance sheet, they do not affect the domestic monetary base, and the use of SDRs has no inflationary effect. In this case, the additional reserves are not used for interventions in the currency markets. However, if SDRs are used to cover an inflationary monetary expansion that is already going on and to finance a balance of payments deficit (arising, for instance, from domestic inflation) that is not sustainable in the long run, SDRs make a more inflationary policy possible. In this case, the additional reserves obtained from SDRs are used for interventions that defend an exchange rate for some time and camouflage the discrepancy between monetary policy and an exchange rate target.

Interestingly, Mussa admits that easy access to international reserves for countries with an acute shortage of reserves is insufficient to establish a global need. As a matter of fact, he points out “that the credibility of the position of many proponents of SDR allocations is not strengthened by the fact that they are persistent net users of SDRs.”

The incentive issue for deficit countries becomes apparent when conditional IMF credits and the unconditional use of SDR allocations are compared. Conditionality imposes conditions on the stabilization policy of a country that requires structural changes and institutional reforms. SDR allocations do not have a similar impact that allows deficit countries to finance balance of payments disequilibria and to postpone necessary adjustments. Thus, SDRs represent a moral hazard problem for the stabilization policy of the deficit country and give the wrong incentive. Inasmuch as SDR allocations induce even one country not to follow a stability-oriented policy, they establish the wrong incentives (Sachverständigenrat, 1995, p. 244). Institutional arrangements with wrong incentives are not good institutional arrangements. It seems to me that Mussa plays down these policy costs of instability.²

Between the lines, distributional considerations enter into Mussa’s argument in favor of providing access to liquidity at low (or in Mussa’s terms “zero”) cost (“There, but for the grace of God, go I”). Without being explicitly mentioned, the political demand for linking SDR allocations and economic development is nevertheless in the background. Here the problem arises as to what weight should be given to equity considerations in monetary institutional arrangements. In some domestic policy issues where “needs” are articulate, institutional safeguards—including constitutional restraints—have been implemented that let such overall restraints as a budget restraint for the government or for a country (in the form of the balance of payments) dominate other decisions. Such institutional arrangements make it harder to trade short-term (political) benefits for long-term (economic) costs. Examples are constitutional budget constraints and the institutional arrangement to depoliticize the money supply with the institution of an independent central bank. This example should remind us that equity considerations should not play any role in designing the institutional arrangement for international reserves.

The analogy to the domestic economy is telling. Poor people are short of money; this cannot be a reason to print more money. Therefore, “it makes no sense whatever to talk about the reserve adequacy problems of a subgroup of the international community” (Chrystal, 1990, p. 14). SDR allocations cannot substitute for the reduced willingness of industrial nations to finance a real resource transfer out of their government budgets, that is, out of savings.

The overriding issue of our debate on the future of the SDR is, of course, “whether the IMF should still be in the business of supplying reserves through the SDR mechanism,” as Mussa correctly puts it.

The international economy today is different from the time of Bretton Woods. Consider a scenario with n currencies and n central banks steering the national money supplies according to some criterion of price level stability. The central banks may directly target the price level, or they may steer monetary aggregates so as to keep the price level (relatively) constant. For the sake of argument, consider a case where all the countries increase their money supplies according to the growth of their production potential, correcting for a change in the velocity of money. If all countries move within these limits and if fiscal policy (and other economic policies) do not contradict monetary policy, exchange rates would remain stable.

If a country deviates from this international concert by allowing a higher national inflation rate, expectations for exchange rate variations will build up and movements of portfolio capital will affect exchange rates and force the currency to depreciate (as has recently been experienced in Europe). Expectations of exchange rate variations will also form in line with long-run changes in the supply side. Thus, the international monetary system can be understood as an interplay of the purchasing power parity (in a very broad interpretation) that forms the exchange rate expectations and of the interest rate parity that determines capital movements (especially of portfolio capital) and the short-term movements of the exchange rate. Exchange rates can overshoot, but, in principle, financial markets have a disciplinary function for national monetary policy and stabilization policy in general.

If national central banks need international reserves, they can obtain them in several ways. One way is for a country to run a current account surplus. A country gives up domestic goods and obtains an entitlement for foreign goods, either today or in the future, International reserves are thus obtained by having an excess of savings (private plus public sector) over investment. Another way is for a country to run a deficit in the capital account and thus obtain international reserves. This, however, implies repayment of debt later. It also depends on whether the country is creditworthy. Finally, a central bank can obtain foreign currency through portfolio shifts. For instance, it can buy foreign financial assets with domestic currency while at the same time foreigners buy domestic financial assets (for instance, shares of a firm) with foreign currency (Chrystal, 1990, p. 13).

In all these cases, countries incur costs of obtaining international reserves. They enjoy the benefit of having international reserves, which can buffer real adjustment problems.

In such a setting—which is characteristic of today’s world—central banks have ample options to obtain foreign currency. The concept of “liquidity shortage” as a systematic phenomenon for the world as a whole does not make sense. Of course, there are costs to obtaining reserves, but there is no supply restraint for reserves if they are not supposed to be obtained at a zero price or a low price. Now it is even being questioned whether a structural reserve adequacy problem existed in the 1960s (Chrystal, 1990, p. 14). This brings us back to the concept of global need. The term need is a moral or a political category, not an economic one. There are many needs in the world, and we are not able to satisfy all of them. For a need to become an effective demand, an institutional setting including prices (and costs) has to be specified under which the need can be revealed. Otherwise, a need cannot be defined.

According to this reasoning, monetary policy is inseparable from exchange rate policy; this, incidentally, requires that central banks, and not national governments, be in charge of exchange rate policy. It is questionable to talk of a “need for international liquidity” without looking at national money creation (Salin, 1990, p. 77). A country’s demand for international reserves clearly depends on its national monetary policy (and other stabilization policies) as well as on its exchange rate target. If there is an exchange rate target, international reserves represent a buffer allowing excessive money creation while still maintaining the exchange rate for a while. Consequently, the demand for reserves—or is it more appropriate to use the term need?—should increase with the importance of an exchange rate target or, more precisely, with the intensity of the inconsistency between monetary policy and the exchange rate target. When reserves decline, it is a signal that money creation was excessive (Salin, 1990, p. 78), leading to what Mussa calls “the potential embarrassment of devaluation.” Applying this philosophy, we have to define the demand for international reserves on a national level depending on the country’s willingness to accept inflation and devaluation.

To resolve the current issue of new members of the IMF not yet having received SDR allocations, the given volume of SDRs could be reallocated according to each country’s share in the sum of quotas. This would be consistent with the long-run target of reducing the role of SDRs rather than increasing it.

A political compromise may be to endow the new members of the IMF that have not yet received SDR allocations with additional SDRs. This action, however, would require a change in the statutes of the IMF, making the SDR allocation to new members a special case that does not represent a general expansion of SDRs. A general expansion would be a precedent that would open the door for other expansions of SDRs in the future, because it would represent staking a claim in institutional change in the wrong direction. A precedent for the future extension of SDRs should not be established.

So what is the conclusion? Let us ignore the issue of whether there was a structural reserve adequacy problem in the 1960s and whether the creation of SDRs “was a mistake” (Chrystal, 1990, p. 14). If the proposal were made to introduce the special drawing right today, one would not do it. One can leave it to individual countries to obtain their international reserves as they need them; each country should run its own monetary policy according to its own inflation aversion.

For a financial crisis, the SDR is not the right instrument anyway, and the IMF commands enough policy means to deal with such a case (Sachverständigenrat, 1995, p. 243). Insofar as SDRs have an organizational and bureaucratic justification for existing, their role should not be expanded. There is really no future for SDRs. The IMF may be well advised not to link its legitimacy to the expansion of SDRs. It would be better to concentrate on the problem of preventing national financial crises from spreading worldwide and on helping countries to gain access to financial markets.

With respect to the quotation from Adam Smith, I wonder whether Michael Mussa found the right quotation to support his case. The summary sentence for the paragraph quoted by Michael Mussa reads, “Paper is more convenient to the Americans for home trade,” and the summary sentence for the next paragraph in The Wealth of Nations is “while for their external trade they use as much gold and silver as is necessary.”

To conclude, I quote Adam Smith from this next paragraph—and if you substitute international currency reserves for gold and silver, you have the answer to our problem:

In the exterior commerce…, gold and silver are more or less employed, exactly in proportion as they are more or less necessary. Where those metals are not necessary, they seldom appear. Where they are necessary they are generally found (p. 894 in 1937 edition).

Interpreting “Long-Term Global Need” J. de Beaufort Wijnholds

The concept of the “long-term global need” to supplement existing reserves has confounded us for a long time. Just as the Fund struggled with the hard-to-operationalize concept of “fundamental disequilibrium” under the original Articles, it has since the Second Amendment been faced with the need for exegesis of Article XVIII.

Mussa seems to take up the role of theologian with relish, calling on certain countries to love their developing brethren a little more and to realize that, “There, but for the grace of God, go I.” While he is probably not entirely off the mark when suggesting that opposition to or reluctance about SDR allocations has to do with the low cost of holding reserves for industrial countries, I think there is more to it. I believe that, at least for some countries, there is also the concern about the proper functioning of the international monetary system and, closely connected to that, the feeling that considerations of a predominantly development nature should be limited in a monetary institution such as the Fund.

There is much in Mussa’s paper with which I can agree. I particularly agree with his view that the most convincing argument in favor of SDR allocations has become the cost consideration. Coming back to exegesis, however, one could question whether the argument of cost is strictly speaking a valid consideration when deciding upon the “long-term global need.” I am not sure that the architects of the amended Articles had this consideration clearly in mind.

This brings me to another matter of interpretation, namely, the fact—as mentioned by Mussa in his footnote 15—that the Fund’s lawyers believe that the objective of making the SDR the principal reserve asset does not constitute a criterion for allocation. And to digress for a moment, and to refer to his footnote 16, I believe that the only realistic chance to have made the SDR anything close to the principal reserve asset was at the time the substitution account was discussed. It was ultimately rejected on not very clear grounds. After 16 years I still find this regrettable and even wonder whether an attempt at reviving the notion of a substitution account might not be worthwhile. In this respect, I refer to recent reports concerning reserve diversification, particularly by Asian countries. Substituting SDRs for the dollars that central banks wish to switch into yen and deutsche mark could also be attractive from the point of view of preventing unnecessary pressure on the dollar exchange rate.

Returning to the main argument, although Mussa and I are in broad agreement on the desirability of keeping the SDR alive, I have some difficulty with the approach that he and the Fund staff have taken with respect to the quantification of the need for reserves. In my view this approach tends to produce results that overstate the need for reserves.

Let me return for a moment to the advent of widespread floating after the breakdown of the par value system. I agree that the reduction of the need for holding reserves was not as dramatic as was thought at the time, and in fact an article of mine that was published in 1974 argued that floating would generally mean managed floating and that therefore a considerable need for reserves would remain.¹ I do not believe, however, that it is accurate to say that because the ratio of reserves to imports—analytically a rather imperfect indicator of reserve need—has remained roughly constant since the mid-1970s, the need for reserves has continued to grow as it did under the post-Bretton Woods system. I believe that quite a number of countries have over the years accumulated foreign exchange assets through interventions beyond what could be considered an optimal level but did not lose reserves in subsequent periods as they continued to have strong external positions. Industrial countries in weaker positions could generally borrow in the markets to build up reserves. Hence, the fall in the reserves to imports ratio (for industrial countries), which one could have expected, did not occur. Indeed, an analytical case has long been made for the existence of economies of scale in the holding of reserves—the argument going back to the work of Baumol on inventory theory.² The Fund staff does take this into account to the extent that an import elasticity of reserves of 0.85 is applied. However, this figure could be on the high side, particularly for industrial countries.

Let me now comment briefly on indications that reserve levels for quite a number of countries, including some emerging market economies, are higher than optimal. First, the so-called symptomatic method for assessing reserve adequacy, which looks for qualitative signs of a shortage of international liquidity,³ does not point to widespread behavior that may be considered indicative of such shortages (that is, in particular a tendency to impose restrictions on capital outflows and on imports of goods and services, or a tendency to keep interest rates high to protect reserves). On the contrary, liberalization in industrial and many other countries has been triumphant. Also, some countries, such as Japan, have lowered interest rates considerably while still taking in large amounts of foreign exchange. Japan and some other Asian and European countries have accumulated reserves beyond levels that they would conceivably need for future interventions to counteract unwanted pressure on their currencies. Such accumulation has clearly been the outcome of considerations other than a perceived need to hoard such huge amounts of reserves. I would venture to say that quite a few central banks these days are partly acting as de facto investment funds for their governments. One indication of this development is that many central banks are known to have been aiming for higher yields on their reserves and in the process have put part of them in less than fully liquid assets. It could be an interesting exercise to survey individual central banks on their perceived reserve ease as well as on their investment behavior.

This of course does not mean that no countries are suffering from reserve shortages. They certainly exist among the developing countries and particularly among the transition economies. The case for an “equity allocation” of SDRs—providing SDRs to those countries that did not take part in earlier allocations—remains a compelling one in my view. However, this requires amendment of the Articles. And since Mussa’s paper deals specifically with allocations under the present Articles, I will not go into this matter now. The situation under the present Articles is that in comparison with quite a few industrial countries and some emerging market economies with more than adequate or clearly excessive reserve levels, there are developing and transition countries with reserve shortages that in purely quantitative terms are most likely to be relatively small in the global context. And, since under what I believe is a valid interpretation of the concept of global reserve need the existing maldistribution of reserves is not a criterion for allocation, creating new SDRs cannot be the solution to this problem under the present Articles.

Briefly looking into the future, I believe that the creation of a European Monetary Union (EMU) will contribute to a clear reduction in the need for reserves for the participating countries. It is also likely to be reflected in a more than marginal fall in the ratio of reserves to imports for industrial countries and the world as a whole. The Treaty of Maastricht requires countries participating in the EMU to pool their reserves in an amount of ECU 50 billion. (This requirement is based on 15 participating countries, which may not initially be the case. The amount is substantially less than is presently held by these countries.)

The following main effects on international reserves may be expected from the inception of EMU. (1) It should substantially reduce the need for reserves in Europe as intervention needs between participating countries will disappear. (2) Actual reserve holdings of the European central bank plus the participating national central banks will be considerably smaller than were held by those central banks prior to EMU, because holdings of deutsche mark will become assets denominated in euros and therefore domestic assets. This would erase a sizable portion of European reserve holdings without affecting reserve ease.

Although it is too early to say anything about the EMU with any precision, it seems useful to realize that once it is established it will have an important impact on the assessment of the need for international reserves.

Finally, I wish to make a few brief remarks on Mussa’s view that the real difference of opinion concerning the SDR is not about the quantification of the global reserve need but rather about whether the Fund should remain a supplier of unconditional liquidity. Although I take the view that important differences of substance in the area of quantification exist, as I have attempted to explain, I agree with Mussa that more fundamental doubts about the SDR by a number of Fund members may play an important role in determining their position with respect to allocations. I also agree with him that the argument of SDR allocations producing visible inflation is not convincing for the amounts that could be termed modest or moderate. The argument concerning the temptation to use SDRs to pursue inappropriate policies holds more sway, I believe, although here too the scale of allocations is relevant, as he observes. Although I agree that modest or even moderate allocations would not seriously undermine the international adjustment process, I feel more comfortable erring on the side of generosity in deciding upon an increase in conditional Fund liquidity (quotas) than I do in deciding upon SDR allocations.

Rationalizing SDR Allocation

John Williamson ¹

Michael Mussa’s paper traces the causes of the long-standing stalemate over the propriety of further SDR allocations in terms with which it is difficult to disagree. The SDR was created in the 1960s as a primary reserve asset to supplement gold, for a world in which the stock of primary reserve assets was presumed to have long-run significance for the evolution of magnitudes like global inflation, and in which it was reasonable to assume that a shortage of primary reserve assets would lead to financial instability (in the form of the feared run on the dollar) or competitive payments objectives. The criteria to govern SDR allocations and cancellations were drafted for that world and enshrined in the First Amendment to the Fund’s Articles.

But then the Bretton Woods system collapsed, and the attempt to restore a modified version of it failed. As a result, the principal primary reserve asset—gold—lost any monetary role. The SDR was redefined as a basket of currencies, most of which were floating against one another. When the Articles were amended a second time to recognize most of the new realities, however, the Article establishing the criteria to determine allocation was left unchanged. It has proved a recipe for deadlock.

Mussa points out that, even in the new world of floating exchange rates, the global level of reserves continues to increase. This increase takes the form of holdings of reserve currencies; there is no longer any danger that their supply will fail to respond to an increase in the demand, or that exogenous, capricious changes in reserve supply will create systemic instability. Hence, none of the consequences of a shortage of primary reserve assets that motivated the creation of the SDR will materialize if no SDRs are created. In the sense that the term “need” was used by its creators, there is no need for an allocation: a country that does not want to see any SDR allocations can appeal to that fact, which is incontrovertible.

Many countries, however, continue to want SDR allocations. They reason that they are going to need to increase their reserves over time, and that it is less satisfactory to do this by borrowing than by receiving SDR allocations, partly because it is more expensive and partly because there is more risk of the reserves evaporating just when they are needed. The countries that can expect to gain most are those that find it most expensive (or, in extreme cases, impossible) to borrow on the international capital market, which tend to be poor countries; but all, except the suppliers of reserve currencies and countries that can borrow on terms as fine as they do, stand to gain. Mussa writes (p. 80 of this volume) that

… the vast majority of the Fund’s membership accounting for about half of Fund quotas² faces net costs of holding reserves that are higher, in many cases significantly higher, than the true economic cost of creating reserves through SDR allocations. This, in my view, falls well into the range of a global need for SDR allocations to supplement other forms of reserve growth.

Now, as argued above, this is not the concept of global need that was in the minds of the creators of the SDR system. But the meaning of words can evolve to fit the times, and if there was a general will to resume allocations, Mussa’s reinterpretation could provide a linguistic veil that would avoid the need to go to the trouble of amending the Articles. The problem is that there is no such general will. And even if one agrees with Mussa that the phrase “global need” cannot reasonably be interpreted to mean that all countries, or that countries with more than 85 percent of Fund quotas, feel a need for an SDR allocation, the “general will” of the Fund is precisely that that can command an 85 percent majority.

That being so, it is necessary to examine why some Fund members resist allocations. Mussa lists three main concerns that have been cited by opponents:

the potential for adding to world inflation, the potential for allowing countries to pursue undesirable macroeconomic policies, and the potential for some countries to increase their absorption of goods and services at the expense of others.

He dismisses these on de minimis grounds. I have never found this a particularly compelling rationale: if something is bad, it is a comfort to know that it is only modestly bad, but that does not make it worth doing. Hence I will try and evaluate the three arguments on their merits.

It will help to have a model of the normal impact of an SDR allocation in our minds. My model is as follows. Think of a typical nonreserve center, or “peripheral,” country, P, that receives an allocation of 100. The authorities seek to maintain the reserve level constant³ by inducing a reduction in external borrowing, which requires either that they sell 100 of their foreign exchange reserves on the exchange market and allow the exchange rate to appreciate or that they expand domestic credit by 100 and hold the exchange rate constant as 100 of their foreign exchange reserves flow out. In either event the private sector will end up with 100 less of debts to the reserve center, R, and the central bank will end up with 100 less of R’s treasury bills. There will as a result be a savings to P of 100 (p—r), where p is the interest rate that R’s private sector charges to P’s borrowers and r is the interest rate that R pays on its treasury bills. Since the SDR interest rate, s, is set as the average treasury bill rate on the currencies in the SDR basket and interest arbitrage keeps these interest rates in line ex ante, s can be assumed equal to r, stochastic factors aside, and it would make no difference to P’s expected saving if its central bank converted some of its SDRs into R’s treasury bills.

With the above model in mind as the standard case, let us consider whether an SDR allocation⁴ would be inflationary. In the textbook case of perfect capital mobility, neither the sale of reserves nor the expansion of domestic credit would have any impact on interest rates or income in P, nor is there any obvious reason why the change in the asset composition of R’s financial sector, from making loans to P to holding more of R’s treasury bills, should influence income in R. In the real world case of imperfect capital mobility, a sale of reserves would be disinflationary while an increase in domestic credit would be inflationary in P; there is no reason for presuming a net inflationary impact in this world of generally flexible exchange rates. But the counterpart to a net disinflationary impact in P is a net cost-inflationary impact in R, while a net inflationary impact in P would be associated with a substitution of loans to P by more of R’s treasury bills in the portfolio of R’s financial sector (just as in the case of perfect capital mobility). Assuming that R’s central bank did not allow these portfolio changes to influence its money supply, there is no obvious reason for an inflationary impact on R.

One can create a somewhat better case for expecting a net inflationary impact by recognizing that the standard model laid out above is not the only possible reaction to an SDR allocation. A country might also increase its reserves or deliberately expand its absorption. In the first case there would be no inflationary impact in either P or R, but in the second case there might or might not be an inflationary impact in P, depending on the mix that was chosen between fiscal and monetary expansion and the resulting extent to which the exchange rate appreciated, but there would in either event be an inflationary impact in R. Whether that impact actually led to higher inflation would of course depend on whether R chose to offset it.

How do these conclusions compare with the view that an SDR allocation is inflationary if and only if it causes an increase in the money supply of the industrial countries (which may be interpreted as the R of my example)? There are two differences. First, I consider the impact on inflation in the periphery P, as well as that in the center R, to be a matter worthy of note. Second, I consider cost-inflationary impacts in R as well as those that might arise from monetary expansion (recall that I am specifically not dismissing effects because I would expect them to be de minimis). I would not quarrel with what I understand to be the position of the Fund staff, to the effect that any significant impact on inflation in the industrial countries depends on their being seduced into monetary expansion.

Consider next the argument that allocations would increase the scope for countries to pursue undesirable policies. There is indeed no guarantee that all countries would react as posited by my standard model above; some might instead expand demand, even if this would be inflationary, which is presumably what worries those who cite this reason to oppose allocations. But, if so, this is just another way of phrasing the previous objection. I thus find difficulty in understanding what additionality this argument is supposed to bring.

So far as the third argument is concerned, it is true that some countries will get the chance to increase their absorption of goods and services, and that this will be partly⁵ at the expense of others. Specifically, the countries that would be enabled to increase their absorption are those that would be able to acquire their reserves more cheaply than otherwise. The ones at whose expense they would increase their absorption are, as analyzed above, the reserve currency countries from whom the P countries borrow in the absence of an allocation.

But does the presumption of some net inflationary impact and of a transfer of resources constitute a case against SDR allocation? After all, the payment of, say, pensions also has an inflationary impact and it also causes a transfer of resources, which is, indeed, the object of the exercise. If the transfer of resources is desired, then one simply takes the attitude that the inflationary impact has to be offset. Typically, that transfer is desired in the case of pensions, perhaps because those from whom the income is transferred can think, “There, with the grace of God, will go I.”

Welfare, which depends instead on the sentiment “There, but for the grace of God, go I,” tends to have a more difficult political passage. And Mussa is right to say that, in the post-Bretton Woods world in which the consequences of an SDR allocation are essentially distributional rather than systemic, a decision to allocate has to be based on the reserve centers acting on that sentiment. Apparently countries deny that sordid considerations of financial gain have any impact on their positions on the desirability of SDR allocations, just like most proponents of welfare reform have convinced themselves that this would be in the best interest of the recipients (because after a transitional phase their recovery of the work ethic will leave them better off). It just happens, however, that a cynic could get a good prediction of which countries have supported and which have opposed allocations by ignoring their disclaimers and positing the same sort of self-interested behavior that we economists customarily impute to human beings.

I conclude that, so long as decisions on allocations are made by monetary technicians whose normal remit is to maximize national welfare and who are told their decisions should be based on an Article that has to be drastically reinterpreted to rationalize the case for an allocation, the probability of further SDR allocations ever being agreed under the present Articles and with present procedures is approximately zero.

This does not necessarily imply that the SDR is doomed. Perhaps the nonreserve centers will one day act on Mussa’s implied criticism of them for having been “persistent net users of SDRs that have already been allocated” and will try to switch into the SDR on a massive scale and then maintain such a wail of complaints about having to hold deutsche mark and dollars instead of SDRs that the reserve centers will be shamed into agreeing to a resumption of allocations. Or perhaps the reserve centers will come to see attractions in an ability to use newly created SDRs to supply conditional liquidity, which might permit the Fund to develop innovative roles such as acting as lender of last resort to the banking systems of countries that established currency boards and fixed to the SDR rather than to a national currency. Or perhaps some high-level political bargain will include an agreement that the present criteria for allocation be replaced by a provision that SDR allocations in a forthcoming basic period will be equal to x percent of the increase in the actual level of reserves in the preceding basic period. But, if the SDR is to have a future, it will somehow have to be liberated from the criterion of global need that was imposed on it in a world that has disappeared and that has become a straitjacket in the world of today.

General Discussion

Alec Chrystal questioned Michael Mussa’s calculation of the benefit of “owned” reserves created through an SDR allocation compared with the cost of borrowed reserves. Mussa was comparing the lower cost of allocating SDRs with the cost of acquiring and holding other reserves through sterilized intervention; but in Chrystal’s view it was more accurate to compare, as Max Corden had suggested, the difference between borrowing through an SDR facility and borrowing in the capital markets at market rates. The numbers would be different, although some recipients who had access to the cheaper borrowing facility would still derive a net benefit.

Chrystal also questioned the inference in Mussa’s paper that an SDR allocation constituted a free good. The SDR was not a free good; it could not be a free good, since it entailed some risk, which Mussa’s paper discounted entirely. The cost of providing reserves depended on an assessment of risk. The market—not the IMF—was the appropriate and professionally equipped risk assessor, and the market should thus determine the cost of providing reserves.

Mussa acknowledged that the creation of SDRs through an allocation could indeed entail a risk, which could be described as a general liquidity risk. In the absence of a complete Arrow-Debreu structure (decentralized, atomistic, markets with perfect information), the possibility existed that all countries would try to use the available liquid assets simultaneously, which would create major congestion—similar to everybody trying to drive on the same stretch of road at the same time. That possibility must certainly be taken into consideration in the creation of international liquidity, said Mussa; and, in fact, the designation mechanism in the SDR system (Article XIX, Section 5) provided a way of dealing with the congestion problem. However, since it had not been necessary to resort to designation for the last seven or eight years, Mussa did not think that liquidity risk posed a substantial problem.

Another risk was that countries might default on their obligations within the SDR system. But, in practice, the incidence of countries not meeting their obligations had been limited—currently representing less than one half, or even one fourth, of 1 percent—of total outstanding SDRs. Admittedly, this risk would be a matter of concern in the event of a large SDR allocation and a move to an enlarged SDR system.

So, although he would not deny that risks were attached to allocating SDRs, Mussa concluded that, for moderately sized SDR allocations, the magnitude of the risks was small compared with the very large disparities between the cost to many countries of acquiring and holding reserves versus the cost of creating them through an SDR allocation.

In measuring the demand for reserves to determine whether there was a need for supplementing the available supply, Christian de Boissieu countered that one must consider both the optimal level and the optimal composition of reserves. With regard to the optimal level, he said the IMF’s practice of relying on the relationship between reserves and imports to estimate the growth of demand for reserves was not wholly reliable. Estimates at the global level of the velocity of reserves—the inverse of the ratio of reserves to imports—also produced an unstable value. Had the IMF, he asked, attempted to estimate a stable velocity function at the global level or for some parts of the world?

The optimal composition of reserves involved three issues, de Boissieu continued: cost of reserves, conditionality, and “controllability.” In organizing a moderate allocation of SDRs, would the IMF, in effect, be conferring on the SDR the characteristics of high-powered money at the global level? An increment to the stock of SDRs, although it would increase the indirect control exerted by the IMF, could be problematic since the IMF was not a true central bank.

Horst Siebert, responding to the controllability issue, argued that having SDRs created an option, based on specific conditions, for a country to take certain actions; but the SDR was not an instrument that could control a country’s behavior.

Mussa, responding to de Boissieu, said that the SDR was essentially an unconditional line of credit and in present circumstances could only be regarded as very low-powered money.

Mussa acknowledged that the IMF had devoted considerable resources in the past to estimaring the demand for reserves—or its inverse, velocity—and had found that such estimates were subject to substantial errors. Nevertheless, in view of the modest level of SDR allocations that had been recommended over the years, he did not think the wide margins of error were a matter of concern. If, on the other hand, the IMF were to move in the direction of the Buira proposal (chap. 6), which involved trying to satisfy the projected growth of demand for reserves of many developing countries, then the IMF’s capacity to estimate this demand would be a matter of grave concern—in addition to the other concerns he had expressed earlier about large allocations.

Alexander Swoboda said that although there was major disagreement about the meaning of the term “need,” everyone agreed that it was an unfortunate choice of word, because it prompted people to ask the wrong question. The right question was not whether the “need” for reserves would be met, since it always would be in some fashion: if not by gold or dollars, then by deflation. In that narrow sense, there could never be a case for an SDR allocation. The appropriate question was whether an allocation was a good way of meeting that need. Therefore, the question that Mussa was asking—can SDRs be used to meet the demand for international reserves at a lower cost—was appropriate, legitimate, and in keeping with the IMF’s purpose of overseeing the welfare of the international monetary system.

Paul De Grauwe asked Mussa to discuss in greater detail his argument, as De Grauwe interpreted it, that small things did not matter if they are small enough; that is, although large SDR allocations produce inflation, small ones did not because of some nonlinearity in the money supply process. De Grauwe said he knew of no theory or model that produced nonlinearities in the money supply process at the national level and was interested to know what nonlinearities Mussa perceived at the international level.

Mussa said that, generally speaking, the main macroeconomic objective of monetary policy in the major industrial countries was stability. Even a fairly large allocation of SDRs was unlikely to induce these countries to change their monetary policy. The reserve inflows generated by other countries exercising their option to use their SDR allocation to buy currencies from the major industrial countries would expand the money supply. But these inflows would likely be sterilized. For the United States, for example, a modest allocation was not likely to induce a reserve inflow of more than 10 percent of the normal growth of the U.S. money base—about $20 billion a year. Inflows of SDR 1 or 2 billion would be sterilized and would not affect U.S. monetary policy.

However, the major industrial countries might not be prepared to sterilize completely the effects of really big allocations that induced yearly inflows of, say, SDR 8 to 10 billion of reserves, which would thereby pose inflationary risks. As the increments to reserve holdings grew larger relative to the monetary base of a major industrial county like the United States, monetary policy could very well be affected.

It was difficult to estimate precisely at what point the risk became significant that monetary policy in the major industrial countries would be pushed off track by the direct receipt of allocations or by reserve inflows from other countries. However, at low levels of allocation—on the order of past IMF proposals and as recommended in his paper—Mussa said the risk of inflation was effectively zero.

With regard to the inflationary effect on smaller countries, Mussa said there was some confusion between the effects of constraints and incentives. SDR allocations did alter the resource constraint somewhat, because they reduced the real resource cost of acquiring and holding reserves, but they did not necessarily alter the stability incentive by encouraging a more inflationary policy. A country that was otherwise constrained might use an allocation to expand somewhat more; but the expansion would result from a relaxation of the constraint rather than a change in the incentive.

There was another side of the argument as well. Some countries—transition economies, for example—might be so severely constrained that the only way they could finance any economic activity was by “resorting to the printing press.” Additionally, their budgets were subject to extreme pressure from the real resource cost of acquiring reserves. It was arguable that if the latter constraint could be relaxed through the less costly mechanism of an allocation, they would need to resort less to the printing press in accordance with their choice of policy options given the constraints under which they operated.

Barry Eichengreen asked Mussa whether the use of SDRs to fund a fast-disbursing, relatively large facility for countries in the midst of sudden financial crises would fall under the definition of “global need.”

Mussa responded that under the current Articles, IMF members could not lend SDRs directly to the IMF for the purpose of creating such a facility. An alternative approach would be a trust arrangement whereby leading IMF members agreed to relend their SDRs in some other form. A more relevant question—albeit difficult to answer—was why not create the facility through a quota increase rather than an SDR allocation.

Returning to the more general issue of long-term global need, Mussa said that the one clear conclusion emerging from the discussions so far was that the concept—whatever its meaning once was—was now ambiguous. But why, he asked, must this ambiguity always be resolved in opposition to SDR allocations? Why did it not afford some degree of flexibility? Unlimited flexibility was not desirable, of course; but the institutional arrangement whereby the mechanism can only be implemented with the consent of 85 percent of the voting power of the IMF provided enough discipline and control to permit some flexibility in interpretation of the concept.

Siebert took issue with Mussa’s assertion that the loosening of a constraint had no effect on incentives. Loosening the constraint once through an SDR allocation, allowing countries to follow a more expansionary policy than they otherwise would have, might set a precedent. The allocation would create an incentive for getting around the constraint the next time.