The “Hard” SDR: An Exploratory Analysis

There has been considerable interest in recent years in the possibility of hardening the SDR, motivated by the desire for an international yardstick of monetary stability. This paper explores various ideas aimed at hardening the SDR in the light of the previous debate on the valuation of the SDR. The paper shows that the construction and implementation of a “hard” SDR that would preserve its purchasing power over goods and services is technically feasible and illustrates this by monthly computations covering the period from July 1974 to July 1993.

Abstract

There has been considerable interest in recent years in the possibility of hardening the SDR, motivated by the desire for an international yardstick of monetary stability. This paper explores various ideas aimed at hardening the SDR in the light of the previous debate on the valuation of the SDR. The paper shows that the construction and implementation of a “hard” SDR that would preserve its purchasing power over goods and services is technically feasible and illustrates this by monthly computations covering the period from July 1974 to July 1993.

In recent years, there has been considerable interest in the possibility of hardening the SDR. This interest is motivated by the desire for an international yardstick of monetary stability and has also been inspired by the debate in the European Monetary System (EMS) about a hardening of the European currency unit (ECU). This paper explores the ideas aimed at hardening the SDR in the light of the various discussions over the years about making the SDR a standard of constant value or purchasing power. It is shown that the construction and implementation of a “hard” SDR that would preserve its purchasing power over goods and services is technically feasible. The decision to adopt such a hard SDR would, nevertheless, depend on a number of policy and operational considerations that are outside the scope of the paper. Section I provides a brief history of the method of valuation of the SDR, focusing in particular on the early ideas aimed at either making the SDR a more stable unit of value or giving it a constant or growing purchasing power. Section II analyzes the “hard ECU” proposal of the U.K. authorities and the subsequent debate in the EMS on hardening the ECU, with particular attention to the proposal of the Spanish authorities of a “hard basket ECU,” with a view to obtaining guidance on the construction of a hard SDR. The next section examines the rationale for a hard SDR and provides an assessment of the impact it could have on the IMF’s financial structure and its financial relations with members, including the value of quotas and the value of IMF credit and members’ repurchases. The technical issues that would need to be resolved if a hard SDR were to be made operational along the lines set out in the paper are then briefly discussed, with some illustrative calculations. Section VI summarizes the discussion.

I. The Genesis of the Hard SDR

Stability in Terms of Currencies

Although the recent interest in the possibility of a hard SDR has coincided with the debate surrounding proposals for a hard ECU, the idea of strengthening the SDR’s value or making it more stable in some sense is decades old. Since the inception of the SDR, considerable importance has been attached by IMF member countries to its attribute of stability, both in its role as a reserve asset and as a unit of account. The interpretation of the concept of stability, however, has differed, depending on the context and the particular method of valuation being considered for valuing the SDR. The alternative approaches to the definition of stability were explored to some extent in the discussion of the valuation of the SDR in 1973–74, when the basis of valuation was shifted from gold to a basket of currencies. In a world of constantly changing relative prices of commodities and currencies, a choice had to be made regarding the medium in terms of which the value of the SDR was to be stabilized. Three possible alternatives are commodities, currencies in general, or a subset of currencies that are regarded as stable.

Although other approaches were discussed and debated, the adoption of the so-called standard basket for valuation of the SDR1 meant that the concept of stability adopted was in terms of a specified group of currencies, i.e., those included in the SDR basket. This assured the holder of SDRs the same spread of risk as would have been achieved by diversifying reserve holdings into the currencies in the basket in the proportions used to construct the basket. Thus, if a country’s import composition in terms of currency denomination approximated the currency composition of the basket, the effect would be to insulate the purchasing power of the SDR over imports from exchange rate changes.

The standard basket’s value, however, is not stable in terms of individual currencies. Thus, an appreciation (depreciation) of any one currency in the basket in terms of all other currencies raises (lowers) the value of the SDR in terms of those other currencies. If one wanted to give the SDR a more stable value in terms of its component currencies than that resulting from the standard basket approach, it would be necessary to introduce increases in the amount of each currency in the basket at periodic intervals. This suggested the alternative approach of an asymmetrical basket. Under this approach, the value of the SDR would be set equal to that of a basket of currencies, but whenever any currency in the basket was devalued or depreciated, the number of units of that currency in the basket would be increased in proportion to the extent of the depreciation. The rationale behind this procedure was to prevent depreciations of currencies in the basket from reducing the transactions value of the SDR in terms of other currencies in the basket. However, under this approach, an appreciation of any currency in the basket would still raise the value of the SDR in terms of other currencies, as under the standard basket. Thus, the asymmetrical basket would put a floor under the value of the SDR in terms of its basket currencies, but would not prevent its appreciation as a result of a basket currency’s appreciation.

Under the third variant considered at the time—the adjustable basket—the treatment of depreciations of currencies in the basket under the asymmetrical basket approach would also be applied to appreciations of currencies, thereby preventing the exchange rate changes associated with all appreciations or depreciations of the currencies in the basket from influencing the value of the SDR in terms of other currencies.2 Although the standard basket was preferred over the other approaches on account of its advantage, above all, of simplicity and understandability, the idea, inherent in the asymmetrical basket, that the value of the SDR could or should be protected from erosion or even be strengthened from time to time, resurfaced in various discussions of the valuation of the SDR. Indeed, in the early discussions of the IMF’s Executive Board on this question, the Japanese Executive Director had supported the view that the value of the SDR should be based “on the strongest currencies,” that is, those appreciating in the exchange markets.3 However, this idea did not find sufficient support at the time.

The principal weakness of the asymmetrical basket was that it had no operational meaning in a world of floating exchange rates. The notion of an asymmetrical basket was not easy to implement in such a world because it required a determination of which currencies were appreciating or depreciating, with reference either to par values for at least some currencies in the basket, or to a clearly defined base period from which the relative exchange rate changes would be measured. In a world of floating currencies, no such common benchmark exists. The ease of operation and adaptability of the standard basket to a floating exchange rate regime probably proved to be its most important attribute, resulting in its adoption over the other alternatives considered. Indeed, if stability meant a stable average value in terms of its component currencies, the standard basket alone offered an unambiguous and consistent valuation of the SDR irrespective of the nature of the exchange rate regime. In addition, it permitted adoption of a formula for the SDR interest rate that was guaranteed to preserve the yield on the SDR constant relative to that on currencies in general.

Stability in Terms of Commodities

The principal concern about valuing the SDR in terms of the standard basket was that an asset that performed with the “average” of currencies would not be sufficiently attractive to establish itself in an inflation-prone world. If the SDR could not be made stronger through an asymmetrical basket, some other means, such as a commodity link, was considered by some as a promising route. The idea of establishing a stable value for the SDR in terms of commodities rather than in terms of a group of currencies had obvious attractions, because reserves are held in part to enable countries to finance temporary deficits in their balance of payments and, therefore, the ability of reserves to finance a given volume of imports was regarded as critical. Despite this strong argument for stabilizing the SDR’s value in terms of its purchasing power over commodities, the extent to which a reserve asset like the SDR should maintain its value in terms of changes in price levels was not explicitly addressed at the time the SDR was negotiated. In the IMF’s Articles of Agreement, the unit of value of the SDR was stated in terms of a weight of gold, which was equal to the par value of the U.S. dollar.4

The idea of establishing the SDR’s value in terms of a group of commodities rather than a group of currencies found its most concrete expression in the proposal for an international commodity-reserve currency. The theoretical antecedent to this idea can be traced to proposals such as that by Benjamin Graham to define the U.S. dollar in terms of a fixed weight basket of 23 commodities and for the Federal Reserve to issue notes against warehouse receipts for the basket thus defined (see Hart, 1966). Graham selected his commodities on the strength of both their economic importance and their storability, the list varying from coal to wood pulp. The proposal, made in the 1930s, was motivated by a desire to counter the depression, in the belief that support for commodity prices would help stabilize overall economic activity. By the same token, sale of the commodity basket was expected to limit inflationary pressures in a boom, both by supplying commodities out of stocks and by contracting the money supply. The idea of a “tabular” standard, advocated by Irving Fisher, is the logical extension of the commodity-reserve money to the entire basket of goods and services in a national economy.

In the mid-1960s, the idea of a commodity-reserve currency was revived in an international context by Hart, Kaldor, and Tinbergen (1964). This proposal was updated for the post-SDR world by Hart (1976). He suggested defining an international reserve asset such as the SDR as a basket of standardized and storable commodities, with the IMF purchasing the basket of commodities, aiming at an amount equal to, say, 25 percent of annual world trade in these commodities and issuing SDRs in exchange. The SDRs so issued would be the principal source of new international reserves. Hart offered an illustrative list of 31 commodities that could make up the basket. The SDR over time would maintain a stable value in the commodity basket through purchases or sales of the basket, within a margin of plus or minus 5 percent. The proposal thus involved the creation of an international currency anchored in a basket of economically significant commodities.

Although enjoying consistent support from some academic economists, the idea of a commodity reserve currency has had little official support. Its obvious attraction is that it would make the value of the SDR stable in terms of a group of commodities and thus insulate it from erosion in real value. The principal objection to it has been that in the absence of a stock of the commodities comprising the basket, the continuing convertibility of the money denominated in this commodity-reserve unit into equivalent purchasing power could not be guaranteed.5 The storage and turnover costs would also be significant and would be economically wasteful.

If the objective is to stabilize the SDR’s value in terms of goods and services in general, then the approach of defining the SDR as a basket of specific commodities would not be appropriate, mainly because of a lack of sufficient correspondence between the prices of a selected group of commodities and the general price level in the world economy. For instance, as noted by Cooper (1989), a prominent supporter of an international commodity-reserve standard, the price index for the commodities included in the early commodity-reserve basket proposals rose by 177 percent during the period 1947–86, while that for finished manufactures rose by 291 percent, and the price of services in the consumer price index, by 684 percent. Thus, adoption of the suggested commodity basket to define the SDR would not generally prevent the erosion of its value in terms of a broader inflation index.6

Stability in Terms of Purchasing Power

As noted above, when the SDR’s value was redefined in 1973 after the link between the U.S. dollar and gold was broken, there was some discussion of the purchasing power of the SDR and its capital value. The possibility of giving the SDR a “stronger capital value” than would result from the alternative basket approaches, by introducing small proportional increases in the amounts of the basket currencies at regular intervals, was mentioned in the final report of the Committee of Twenty on the reform of the international monetary system. It was suggested that the effects of the resulting capital appreciation of the SDR against the basket currencies on the yield of the SDR could be offset by lowering its interest rate (see Section III). However, the discussion in the Committee’s report did not suggest any link between the rate at which the basket currencies lost purchasing power over goods and services and the magnitude and frequency of the increases in the currency content of the SDR. The idea of a stronger capital value of the SDR was thus a precursor of the hard SDR, defined in terms of purchasing power over goods and services but without an explicit correspondence between the “strength” of the SDR and the “strength” of the individual basket currencies.

The idea of a real SDR, that is, one with constant purchasing power over goods and services, was discussed in the subsequent deliberations of the Executive Board on the valuation of the SDR in 1973–74. However, the predominant view, especially on the part of some of the Executive Directors representing large industrial countries, was that indexation of the SDR in any form was not advisable. The general objection to indexation in any form, strongly voiced at the time by the Federal Republic of Germany, was that it would weaken efforts against inflation by reducing some of inflation’s ill effects, albeit in an incomplete fashion (see de Vries (1985)).

Some consideration was given, however, to a real SDR as a unit of account in international transactions, especially for expressing limits of liability or similar values intended to maintain a constant purchasing power. In the past, such values had often been stated in terms of a gold unit such as the Poincaré franc. The Secretariat of the United Nations Commission on International Trade Law (UNCITRAL) became interested toward the end of the 1970s in an internationally recognized unit of constant purchasing power and requested from the IMF a study of the SDR in this context. The IMF staff recommended the adoption of a unit of value established on the basis of the SDR basket of currencies combined with an international price index composed of national price indices of the basket currencies, with weights corresponding to the weights of the respective currencies in the basket. The UNCITRAL subsequently (in 1982) adopted the SDR as a unit of account for expressing monetary values in international conventions.7 The inflation-corrected SDR was not adopted but was endorsed as one alternative for expressing values whose purchasing power is intended to be protected.

Thus, ever since its establishment, there has been recurrent interest in the idea of a hard SDR, although the precise form it would take has not been fully articulated by its advocates, and several misgivings—in particular, those centered on the advisability of any form of indexation—have prevented a full exploration of its merits. In contrast to this ambivalent attitude toward the SDR within the international monetary establishment, other official and semiofficial international bodies have from time to time shown interest in some version of an SDR of constant value, which could be used in various international contracts as an objective and universally recognized standard of constant purchasing power (see Effros, 1982).

II. The Hard ECU and Hard Basket ECU

The recent interest in the concept of a hard SDR has been inspired, in part, by the debate in the European Community on the proposal for a hard ECU. This section examines briefly the hard ECU proposal as well as the proposals for a hard basket ECU.

The Hard ECU Proposal

The U.K. authorities announced their proposal for a hard ECU in June 1990, in an elaboration of their position on the European Monetary Union (EMU) earlier spelled out in a paper by the U.K. Treasury (HM Treasury, 1990). The U.K. proposal was motivated by the basic premise that the path to EMU should be gradual and evolutionary, that it should be consistent with market forces, and that it should strengthen incentives for price stability.

Under the proposal, the ECU would be changed from a currency basket to a parallel currency with a par value and intervention limits against each of the EC currencies (it being assumed that all EC currencies would be participating in the ERM). A key feature of this new thirteenth currency in the EC would be that it would never be devalued against any other EC currency. Thus, upon any realignment, the value of the hard ECU would move with the strongest currency, instead of moving with the basket.

The proposal envisaged that a new EC institution, the European Monetary Fund (EMF), would be set up to manage the hard ECU. The EMF would issue hard ECUs against surrender of holdings of national (EC) currencies. The proposal seems to envisage that the EMF would initially hold 100 percent of reserves (in the form of national currencies) against its hard ECU liabilities, and that it would set the interest rate on its deposits. Thus, initially the EMF would have the ability to change the composition of EC money supply between national currencies and the hard ECU, but not the total money supply.

The market was expected to exert anti-inflationary discipline as firms and individuals switched from currencies with expected poor purchasing power to those with better prospects. To enhance the normal anti-inflationary discipline exerted by the market on those currencies that are expected to depreciate, the EMF could be empowered to require national central banks to repurchase their own currencies at the EMF for hard ECUs at the exchange rates prevailing at the time when the currency balances were originally deposited with the EMF. As the market for private hard ECUs grew and the EMF acquired credibility, the functions of the EMF could be expanded to resemble those of a national or a supranational central bank, including the ability to engage in open market operations aimed at influencing market interest rates on hard ECUs as well as those on national currencies of EC members; coordinating members’ exchange market intervention against external currencies; and, possibly, extending medium-term balance of payments lending to members. The EMF was also expected to take over gradually from the European Central Bank Governor’s Committee and the European Monetary Cooperation Fund most of the management of the exchange rate mechanism of the EMS and its financing facilities. Nevertheless, the EMF’s key function was envisaged as being the monetary authority for the hard ECU with responsibility for ensuring that it was never devalued against any of the EC currencies.

The hard ECU would be free to vary within the small band of the exchange rate mechanism (ERM) of the EMS against other EMS currencies in line with market demands. It would be the responsibility of the EMF to ensure that the hard ECU was never devalued. If this no-devaluation guarantee is taken as fully credible, it follows that the purchasing power of the hard ECU would be dissipated by inflation less rapidly, or no more rapidly, than any other EMS currency. It would not, however, mean that the hard ECU would provide either stable or predictable purchasing power, as would a constant-value currency, indexed to a cost of living price index. Nevertheless, it would have an advantage over the existing 12 EC currencies in terms of its purchasing power.

Critics of the proposal have noted that this advantage of the hard ECU may not be sufficient to overcome inertia and the costs and uncertainties associated with switching from existing domestic currencies to the hard ECU as a means of payment. This skepticism is based on the historical experience that even in the face of inflation differentials and exchange rate movements that are many times larger than those currently prevailing, or likely to prevail, among EC countries, residents display a strong affinity to the domestic currency for purposes of means of payments and unit of account. This would not preclude the use of the hard ECU by some firms doing predominantly cross-border business or for purposes of denominating travelers’ checks. But the transactions demand for the hard ECU as a substitute for the domestic currencies is likely to evolve very slowly. In the EMU context, there would also be increased uncertainty due to the uncertain prospects of the hard ECU itself becoming the single EC currency and any shifts in its value and characteristics as a result of that process. These considerations lead critics to doubt whether removing existing impediments to the use of hard ECUs in the private sector and a no-devaluation pledge would be sufficient to stimulate a large increase in such use. A public sector intervention, such as making the hard ECU a legal tender throughout the EC or a pledge by EC governments to make it the single currency would help, but such “administered” approaches would be contrary to the competitive spirit of the U.K. authorities’ proposals.

Any reduced inflation or exchange rate risk of the hard ECU would presumably be compensated in the market by a lower nominal interest rate on hard ECU-denominated interest-bearing assets. The growth of the hard ECU as a transactions currency itself might spur demand for interest-bearing hard ECU assets over time. It is, nevertheless, possible that, like the present basket ECU, the hard ECU may become an important investment currency despite the absence of a transactions demand. The hardness of the hard ECU could make it an even more attractive investment currency, irrespective of the growth in transactions demand.

The Hard Basket ECU Proposals

The U.K. proposal for a hard ECU inspired debate and in turn generated alternative ideas. Although there was considerable skepticism about creating another currency alongside the existing ECU, the basic concept of a hard currency had widespread appeal and was reflected in a suggestion by Spain (Government of Spain, 1991) and Germany to harden the existing basket ECU. Under this proposal, the present basket ECU would be revised at any future realignment to ensure that it was never devalued vis-à-vis any of the basket currencies. Thus, the proposal tries to accommodate the concept of hardness within the existing basket structure of the ECU. Hardening in this context refers to the adoption of any measure that would make the value of the ECU less dependent on the weaker, or depreciating, currencies of the EMS. In the Spanish proposal for a hard basket ECU, the amounts of the individual national currencies would be adjusted in the event of any realignment in the ERM, so as to preserve a fixed central exchange rate between the ECU and those currencies not experiencing devaluation. Similar to the U.K. authorities’ proposal, the Spanish proposal envisaged the creation of a European monetary institution that would not interfere with the conduct of monetary policy by national central banks but, inter alia, building on existing practices in the private ECU market, would foster its development by establishing a direct link between the official and the private ECU.

The German authorities also proposed a similar hard basket ECU, but without the creation of an official monetary institution that would establish a formal link between the official and the private ECU. The existence of such a link or de facto narrow limits on the permitted deviation between the hard basket ECU’s market value and its theoretical value would be important in making the hard basket ECU viable for private financial use.

Another variation of hardening the existing ECU was the proposal by the European Commission, which called simply for a freeze in the currency composition of the ECU by ruling out future recomposition of the currency basket. This proposal thus envisaged a gradual hardening of the ECU. With the quantities of each EC currency in the ECU fixed, the weight of any appreciating currency in the ECU basket would rise, while that of the depreciating currency would decline.

It is important to note that all the proposals for hardening the existing basket ECU had as their objective an ECU that would not lose value with respect to any of the basket currencies when any parities were realigned. That would not rule out a softening of the ECU against one of its basket currencies at any moment in time. An application of the idea of an asymmetrical basket, as discussed in the previous section, would be operationally feasible only in the case of currencies with parities or par values with reference to which any appreciation or depreciation of a currency could be measured. Any attempt to apply the hard ECU formula to intra-realignment periods would lead to nonsensical results and instability in the ECU’s value. In recognition of this fact, all the proposals to harden the basket ECU have been restricted to realignments, which would provide a benchmark to define a depreciation.

At the Maastricht summit in December 1991, the EC member states agreed to a series of amendments to the Treaty of Rome. Apart from the major institutional innovations leading up to the prospective economic and monetary union, including the establishment of the European Monetary Institute, which is, inter alia, responsible for the development of the ECU clearing system and facilitating the use of the private ECU, the treaty included a provision saying that “the currency composition of the ECU basket shall not be changed. From the start of the third stage (of EMU) the value of the ecu shall be irrevocably fixed. …” (Council of European Communities, Article 109g, p. 39.) The European Commission’s proposal to freeze the ECU basket was thereby adopted.

III. Rationale for a Hard SDR

The present method of valuating the SDR strikes a carefully developed balance between, on the one hand, a built-in adaptability to changing circumstances of the international economy—through the practice of periodic revision of weights—that seeks to ensure continued realism of the method, and, on the other hand, stability and predictability. A change in this principle of valuation is justified only if there are commensurate benefits from it both to the role of the SDR in the international monetary system and to the operation of the SDR in the IMF’s transactions with its members.8 This section addresses the question of what benefits and costs might be attached to hardening the SDR, if such an approach to its valuation were to be adopted.

A Yardstick of Price Stability

The need for a universal unit of account of constant value for purposes of international legal conventions has been felt for some time. Since all currencies in the SDR basket continually lose value in terms of goods and services that they can purchase, the SDR, per se, does not guarantee the maintenance of value in terms of purchasing power. Various groups such as the Committee on International Monetary Law of the International Law Association have called for an international unit of constant value for facilitating international legal conventions.

A major attribute of a universal unit of account, which influences the willingness of institutions and other economic agents to use it for denominating obligations, is its ability to retain its value in terms of goods and services. This attribute tends to be less crucial for units of account for denominating financial instruments because changes in the purchasing power of such units generally tend to be reflected—and hence compensated for—in the interest rates attached to such instruments. Nevertheless, a universal unit of account of constant value in terms of a basket of all goods and services would be desirable.

The definition of the SDR’s value, as adopted in 1981, has succeeded to some degree in maintaining the SDR’s real value, because the rates of inflation of the five currencies in the SDR valuation basket have generally been lower than inflation rates in many other IMF member countries. However, this has not prevented a steady erosion in the SDR’s value in terms of goods and services (see Figure 1 and Table 1). Thus, the average value of the SDR in terms of goods and services eroded by 75 percent in the period 1980 to mid-1993, reflecting the weighted average (with SDR basket weights) of consumer price inflation in the five countries whose currencies form the SDR valuation basket. Between mid-1974—when the SDR’s value was first defined as a basket of currencies—and mid-1993, it suffered from an average inflation of 197 percent. This steady erosion of the real value of the SDR could be a reason for its limited adoption as a unit of account by the private sector, resulting in turn in a limited demand for SDR-denominated instruments.9

Figure 1.
Figure 1.

Deflator for the Hard SDR

(July 1974=100)

Citation: IMF Staff Papers 1994, 003; 10.5089/9781451973303.024.A004

Note: The deflator for the hard SDR is calculated by taking the weighted average of the consumer price inflation in the five basket currencies.
Table 1.

Deflators for SDR Component Currencies and the Hard SDR

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Note: The deflators are derived from consumer price indices in the respective countries. The deflator for the hard SDR is derived using the prevailing SDR basket weights.

An SDR with a constant real value would offer the international community a supranational unit of account of world standing and would spur its use for denominating obligations. Since it would be regularly calculated and published by the Fund, the hard SDR could form the basis for contracts among Fund members or among private contracting parties. The hard SDR would be expected to appreciate in relation to the conventional SDR and against currencies in general. This expectation would make it an attractive store of value. Its expected yield would be competitive with that on currency-denominated assets, although, as discussed below, its interest rate would tend to be relatively low. The increased demand for private SDRs could increase the demand for official SDRs as well. A unit of stable purchasing power in which contracts could be written is also likely to facilitate expansion of world trade and improve international resource allocation.

As noted above, the UN Commission on International Trade Law has adopted the SDR as a unit of account and has expressed its view that an international unit of constant purchasing power would be useful. A number of other international organizations use the SDR as their unit of account or as the basis for their unit of account. These include the African Development Bank, the Arab Monetary Fund, the Asian Clearing Union, the International Development Association, the International Fund for Agricultural Development, and the Islamic Development Bank. In addition, various international conventions use the SDR as a standard of value in which to express monetary magnitudes, notably conventions that express limits of liability for carriers in the international transport of goods and persons. In some cases, the SDR has been adopted in these conventions to replace the Poincaré or Germinal franc, both of which are defined with reference to fixed quantities of gold. For instance, the unit of account for the Universal Postal Union and the International Tele-communications Union is the gold franc, which has been declared to have a specified relationship to the SDR. Therefore, in practice, international postal and telecommunication accounts are maintained in SDRs. In these and other contexts where a convention or international contract needs a unit of account of stable value, the hard SDR would be very useful.

The hard SDR would provide a clear yardstick for price stability in the world economy. Therefore, any country that desired price stability could, in principle, implement such a policy by pegging its currency to the hard SDR. The hard SDR could thus play a role as an unambiguous international monetary anchor for price stability.

Impact on Fund Financial Structure

As a reserve asset of constant purchasing power, the demand for hard SDRs would be expected to increase with the prospect of inflation. This would introduce a new element to the consideration of the desirability of allocating SDRs. It would seem that an allocation of such hard SDRs would be appropriate despite—indeed, on account of—inflationary tendencies in the world economy. Hard SDRs would, over time, tend to be substituted in reserve holdings for currencies of countries experiencing inflation. It is sometimes argued that the hard SDR would, through this process of substitution for inflating currencies, tend to exert a disciplining influence on the adjustment process in the world economy. The validity of this view is open to question since the mechanism through which the discipline is exerted is not very transparent. In any case, a hard SDR would at least maintain the proportion of SDRs in total reserves in the face of inflation, even if no new allocations were made.

The concern voiced by some in earlier debates on the hardening of the SDR, regarding the advisability of indexing the SDR, would need to be addressed. The concern stemmed from the belief that indexation of a reserve asset would imply accommodation of inflation and would remove the discipline on governments. The proposed role of the hard SDR as a unit of account of a constant real value, however, does not seem to accommodate inflation. Rather, it recognizes the fact that inflation, in the real world, erodes the purchasing power of the five basket currencies, and it offers a standard of value that is free from such erosion.

The hard SDR’s attractiveness as an asset whose value is protected from inflation would probably lead to a greater demand for it by IMF members, although its lower interest rate would tend to offset some of its attraction. If demand for it were to increase, this might necessitate a reassessment of the policy and procedures on SDR transactions and the optimal size of SDR holdings by the IMF and its members.

An important consequence of a hard SDR would be that on the size of the Fund as measured by quotas. Since quotas are denominated in SDRs, the shift to a hard SDR would imply that the real value of the size of the IMF would be maintained even when inflation erodes the values of the SDR basket currencies. As illustrated in Figure 2 and Table 2, if the SDR had been protected against erosion by inflation, the size of IMF quotas would have kept pace with the expansion of world trade and output caused by inflation. If quotas were denominated in hard SDRs, the general increases in quotas every five years would reflect only the increase necessitated by real increases in world trade and output. These general increases would therefore be smaller than those needed to keep pace with real changes in the world economy as well as the effect of inflation. To a large extent, however, the process of increasing quotas to reflect world inflation would become automatic if quotas were denominated in hard SDRs. The difficulties associated with the protracted process of consent to general increases in quotas would therefore be considerably alleviated by the adoption of a hard SDR for denominating IMF quotas. The need for general increases to allow for real growth in the world economy would, however, remain.

Figure 2.
Figure 2.

Value of Fund Quotas Fixed in Hard SDRs

(July 1974–July 1993)

Citation: IMF Staff Papers 1994, 003; 10.5089/9781451973303.024.A004

Table 2.

Fund Quotas: Actual and in Hard SDRs

(In billions of SDRs)

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Quotas were raised by 50 percent under the Ninth General Review.

This would be a potentially important gain. The erosion of IMF quotas by inflation has been a recurring issue. For example, Polak (1984, pp. 252–53), in discussing the declining role of the IMF vis-à-vis the commercial banks in financing for developing countries, noted that “inflation, and quota increases that did not take adequate account of inflation had, by the middle seventies, reduced at least by half the quotas as a percent of imports both for the membership as a whole and for its main customers, the non-oil LDCs.… As a result, the amount of financial assistance that a country could expect from the fund (sic) under its prevailing policies became too small, in relation to the size of its payments problem, to make recourse to the Fund an acceptable political choice.” This inadequacy of Fund quotas led the IMF to take major remedial steps, including an expansion of access limits, a shift of emphasis from one-year to three-year arrangements, and a lengthening of the maximum period of repayment under the Extended Fund Facility. The adoption of a hard SDR would make a major contribution to alleviating the recurring problem of inadequacy of quotas and, therefore, of the financial assistance the IMF can extend, in relation to the magnitude of its members’ payment imbalances.

Similarly, the stock of allocated SDRs, if it were to be denominated in hard SDRs, would rise with the increase in the world price level. For illustrative purposes, Figure 3 shows the current stock of SDRs if each of the six allocations so far had been denominated in hard SDRs. Without any additional allocations, the outstanding stock of hard SDRs would have amounted to the equivalent of some 38 billion current SDRs, compared with the actual size of 21 billion SDRs.

Figure 3.
Figure 3.

SDR Allocations in Hard SDRs

(July 1974–July 1993)

Citation: IMF Staff Papers 1994, 003; 10.5089/9781451973303.024.A004

Another important consequence of a hard SDR for the IMF’s operations would be the impact on real debt servicing by IMF members on outstanding IMF credit. Since IMF credit would be denominated in hard SDRs, and the repayment would also be in hard SDRs, the impact of inflation on debt service would be eliminated. As is well known, inflation results in early repayment of the principal when debt service is measured in real terms. Shifting of IMF credit to a hard SDR basis would therefore eliminate this implicit early repayment of principal, thereby (implicitly) lengthening the maturity of IMF credit. A similar effect would apply equally to members’ credit positions vis-à-vis the IMF.

The interest rate on the hard SDR would be a “real” interest rate, set by deflating the basket market interest rate by the rate of change in the SDR deflator. This would not present any difficulties, since the low interest rate on the hard SDR would be interpreted as a real or inflation-adjusted interest rate.10

IV. Implementation of the Hard SDR

The Asymmetrical Basket

The implementation of an asymmetrical basket is feasible in a world of fixed but adjustable exchange rates, because in such a world there is a clear benchmark, that is, the current parity or central rate, against which a devaluation or depreciation can be defined. The Spanish authorities’ proposal for a hard basket ECU is, in fact, an application of the asymmetrical basket idea to the basket ECU, with devaluations defined in terms of downward realignments of EMS parities. The downward adjustments of the exchange rates of the basket currencies are offset by raising the number of units of the depreciating currency in the basket in proportion to the size of the depreciation.

In the current context of freely floating currencies of the major countries, stability of the SDR’s value is not easy to define if it is restricted to mean stability in terms of currencies. If the objective, like that of the asymmetrical basket, is to prevent depreciation of currencies in the basket from reducing the value of the SDR in terms of other currencies, it would be necessary to set benchmark levels on the basket currencies’ exchange rates with reference to which a depreciation or an appreciation could be defined. Such benchmark levels would necessarily be arbitrary.

Despite these fundamental difficulties with a hard SDR defined in terms of an asymmetrical basket, it could, in principle, be constructed at a technical level if a date—a necessarily arbitrary one—were picked, from which any appreciation or depreciation would be measured. However, the frequency with which the basket is changed would need to be decided, say, monthly. A daily change would imply an unstable hard SDR, because in a floating exchange rate world, a currency that appreciates vis-à-vis the benchmark date may depreciate the following day. Such instability in the composition of the SDR would be a major drawback of the asymmetrical basket. In any case, it would be difficult to attach any economic significance to a hard SDR based on such arbitrary benchmarks and deviations of market exchange rates from these levels.

SDR of Constant Purchasing Power

In a world of generalized floating of major currencies, the most meaningful definition of a hard SDR would be in terms of maintaining the hard SDR’s purchasing power over goods and services. At a technical level, this can be done in a number of ways. For instance, the hard SDR could be defined in terms of a basket of commodities, with an agreement on the commodity price quotations to be used in calculating its value in terms of currencies. The major difficulty with such an approach, however, (as noted in Section I) is that the markets for individual commodities are, in the short as well as the medium term, subject to several special influences, including speculation, which result in their prices deviating, often sharply, from the general price level. The price of a collection of primary commodities would tend to be more stable than that of any single commodity, but still less stable than a general comprehensive price index, such as a consumer price index or GDP deflator.

The most suitable method of valuation to establish a hard SDR is therefore one where the amounts of currencies in the SDR basket are adjusted periodically (say, monthly) to reflect the loss of purchasing power of each currency, as measured by its rate of inflation. For illustrative purposes, the consumer price index is used as a measure of inflation. Table 3 shows the amount of each currency that would have been in the SDR basket each month if the hard SDR had been established in July 1974 when the basket method of valuation was first adopted. The hard SDR’s currency basket is shown in Table 2 and exchange rates of the hard SDR for the five basket currencies are shown in Figures 48.11 Figure 9 shows the number of U.S. dollars in the SDR basket and in the hard SDR basket.

Table 3.

Amounts of Currency in the Hard SDR

(In units of respective national currencies)

article image
Source: IMF staff calculations. For more details, see Appendix tables in Thakur (1994).
Figure 4.
Figure 4.

U.S. Dollar/SDR Exchange Rates

(July 1974–July 1993)

Citation: IMF Staff Papers 1994, 003; 10.5089/9781451973303.024.A004

Figure 5.
Figure 5.

Japanese Yen/SDR Exchange Rates

(July 1974–July 1993)

Citation: IMF Staff Papers 1994, 003; 10.5089/9781451973303.024.A004

Figure 6.
Figure 6.

Deutsche Mark/SDR Exchange Rates

(July 1974–July 1993)

Citation: IMF Staff Papers 1994, 003; 10.5089/9781451973303.024.A004

Figure 7.
Figure 7.

Pound Sterling/SDR Exchange Rates

(July 1974–July 1993)

Citation: IMF Staff Papers 1994, 003; 10.5089/9781451973303.024.A004

Figure 8.
Figure 8.

French Franc/SDR Exchange Rates

(July 1974–July 1993)

Citation: IMF Staff Papers 1994, 003; 10.5089/9781451973303.024.A004

Figure 9.
Figure 9.

Number of U.S. Dollars in SDR and Hard SDR Baskets

(July 1974–July 1993)

Citation: IMF Staff Papers 1994, 003; 10.5089/9781451973303.024.A004

Under the method implemented for illustration, there is a discrete change at the end of each month in the number of currency units comprising the SDR basket. To avoid such a discrete jump, a smoothing procedure involving a moving average of rates of monthly inflation might need to be used. In such a case, it would be possible to preannounce the daily changes in the currency basket amounts at the start of each month, based on a moving average of rates of inflation in the preceding months.

V. Some Technical Issues

The implementation of a hard SDR with constant real value would require the resolution of a number of technical questions, including clarity of definition and continuity of the calculation of the SDR’s value. The SDR is officially calculated by the IMF daily, while its value is calculated continuously as needed as a unit of account in private financial markets.

Frequency of Adjustment

The first decision to be made would be the frequency with which the amounts of currencies in the valuation basket would be adjusted in order to correct for erosion (or accretion) in its real value. The competing considerations here would be the extent to which the SDR’s real value is eroded over different periods and the desirability of avoiding large, abrupt changes in the SDR’s value when the adjustments take place. The practical constraint on the frequency with which the adjustments in the currency amounts can take place is the availability of data on price inflation for the countries whose currencies comprise the basket. A period of a month, therefore, would seem to be the minimum feasible interval for adjustments. If the rates of inflation of the currencies in the basket are very low, say, below 4 percent, quarterly or semiannual intervals could be considered. The shorter the adjustment interval, the smaller the change to be made each time.

Private market participants would try to anticipate the changes in order to build them into the yields on SDR-denominated financial instruments. Since monthly changes in price indices are more difficult to forecast than quarterly or annual changes, such adjustments would be more difficult for private markets to anticipate. However, if the rules for adjusting the basket are clear and well publicized, the market would have a fair chance at forecasting changes in the value of the SDR.

Choice of the Price Index

Given the objective of preserving the real value of the SDR in terms of a comprehensive basket of goods and services in the world economy, the GDP deflators of the countries whose currencies form the SDR basket would seem to be appropriate measures of inflation. However, the long lags with which these are published would argue against their selection. If it were to be decided to use GDP deflators, the highest frequency of adjustment ought to be quarterly rather than monthly.

Consistency with the IMF’s Articles of Agreement

An important technical and legal issue concerns the requirement under the present IMF Articles of Agreement that a new SDR basket have the same value as the old one on the last day the old one is still in operation. Under the adjustment made each month to establish the value of the hard SDR, there would obviously be a significant departure from the present method because the value of the baskets would actually change—in fact, that is the point of the exercise—on the days when the new baskets came into effect. The question of whether the Articles could be interpreted in such a way that the hard SDR basket adjustment to be done each month (or other selected interval) would be compatible with them, or whether an amendment of the rules would be necessary, is an open question and needs further investigation.

Implications for the Interest Rate on SDRs

The establishment of a hard SDR would imply a concurrent change in the method of calculating the SDR interest rate. This should not present any additional technical difficulties because, by adjusting the weights of the SDR interest-rate basket in line with the adjustment in the currency basket, the interest rate on the hard SDR could be calculated daily. This interest rate, being inflation adjusted, would be considerably lower than the one on the nominal SDR, which is a weighted average of market interest rates prevailing in the five countries whose currencies comprise the SDR basket.

VI. Summary and Conclusions

This paper has reviewed alternative concepts of a hard SDR and concludes that, under the present conditions of generalized floating of major currencies, the asymmetrical basket technique discussed in the early 1970s is not a feasible option. The alternative of defining the SDR’s value in terms of a specific commodity basket along the lines of the commodity-reserve currency proposals is also ruled out as unrealistic and unlikely to achieve the goal of stable purchasing power of the SDR. A proposal to change the basket of the current SDR in line with the inflation rates of its five component currencies so that the value of the SDR is protected from erosion by inflation was then discussed. The calculation of such a hard SDR basket was illustrated for each month over the period July 1974 to July 1993. Some of the implications of this proposal both for the IMF’s operations, and more generally, were discussed. The hard SDR could provide a unit of account of constant purchasing power, which can be useful in international trade and commercial contracts. It could also provide an anchor to which currencies could be pegged if it were desired to maintain their purchasing power constant in terms of a basket of goods and services of the five countries whose currencies are in the basket. The adoption of the hard SDR to denominate IMF quotas would insulate quotas from erosion by inflation. The value of SDR allocations denominated in hard SDRs would similarly be protected from erosion by inflation. The hard SDR would carry an inflation-adjusted real interest rate, which would be below that on the present SDR. However, the impact that the adoption of the hard SDR would have on the IMF’s operations, as well as the technical issues in its construction, would need to be investigated further.

Construction and implementation of a hard SDR that would preserve its purchasing power over goods and services is technically feasible. The decision to adopt such a hard SDR would, nevertheless, depend on a number of policy and operational considerations that are outside the scope of this paper. One possibility would be to compute and publish the hard SDR as a standard of constant purchasing power and a unit of account available for use for commercial contracts or other purposes without using it to denominate IMF operations.

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*

Subhash Thakur, a Senior Economist in the IMF Institute, received his master’s degree from the University of Poona, India, and his doctorate from the University of California, San Diego. This paper was written when he was in the Financial Relations Division of the Treasurer’s Department. He wishes to thank Warren Coats, Jr., Peter Isard, Anthony Richards, and Orlando Roncesvalles for helpful comments and discussions, with the usual disclaimer. Neeraj Rajpal provided efficient computational assistance.

1

The currency composition and weights of the SDR basket are reviewed and revised every five years so as to include the currencies of the five member countries of the IMF with the largest exports of goods and services during the latest five-year period for which full data are available. The weights assigned to each of the five currencies are then determined on the basis of the exports of goods and services and the balances of each component currency held in the reserves of other members. These weights are used to fix the amounts of each individual currency in the basket. Calculating the value of the SDR in terms of a basket of fixed amounts of currency has the result that the weight of a currency’s value in the basket changes as that currency’s market value changes. An appreciating currency’s fixed amount will increase its share in the total value of the SDR, and vice versa. For a classification of alternative valuation schemes, including a logarithmic basket, see Williamson (1987).

2

Formally, the SDR’s value in terms of any basket currency j can be calculated on the basis of defined quantities (qj) of each currency i in the basket and the relevant exchange rate between i and j (eij), defined as the number of units of currency j per unit of currency i. Thus,

Vj=Σi=1neijqi.

Under the asymmetrical basket, the quantity qi of a currency in the basket is redefined, when a currency is devalued with respect to its par value Ci, so as to re-establish the initial weight Wi of each currency.

qi=WiCi

The adjustable basket would redefine qi in the above fashion in the case of a revaluation as well as a devaluation of any currency in the basket.

4

This provision was often termed as a gold-value guarantee. However, since the two-tier gold market was already in operation, this “guarantee” was not well defined when the Articles were amended by the Executive Board.

5

The advocates of a commodity standard argue, however, that such money would have stable purchasing power if its quantity were appropriately limited. Indeed, in their view, the ability to enforce such limits is the main virtue of a commodity standard.

6

An approach to the SDR’s valuation based on a representative basket of goods is also suggested as one option to make the SDR a standard of constant purchasing power by Coats (1989). He also suggests that an unchangeable commodity basket—or one with five-yearly adjustments that preserve the basket’s value at the time of each change—is an interesting compromise between the present currency basket and a basket of fully constant purchasing power explored in this paper. The Coats paper explores the broader issue of independence of the unit of account from the medium of exchange and suggests a role for the SDR as an independent unit of account of constant purchasing power. The hard SDR of constant purchasing power explored in this paper is consistent with and in the spirit of Coats’s approach.

7

For a detailed review of this development, see Effros (1982).

8

A change in the principle of valuation of the SDR or a fundamental change in its application can be approved only by an 85 percent majority of the total voting power of the IMF.

9

There are, nevertheless, other obstacles to development of private markets in SDR-denominated assets, which could prevent their expansion. An important impediment is the lack of integration between official and private SDRs. In the absence of a clearing mechanism for SDR-denominated assets, banks and other private transactors are not encouraged to develop instruments and modalities for transactions in SDRs.

10

If the interest rate on the hard SDR turned temporarily negative, as is conceivable, this would have implications for the IMF’s burden-sharing mechanism, necessitating a change in that mechanism.

11

For detailed monthly calculations of the hard currency basket and exchange rates, see the Appendix table in Thakur (1994).

IMF Staff papers, Volume 41 No. 3
Author: International Monetary Fund. Research Dept.