Special Drawing Rights

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its
member countries’ official reserves. Its value is based on a basket of four key international
currencies namely Japanese Yen, US Dollars, British Pounds and Euros, and SDRs can be
exchanged for freely usable currencies. It's neither tangible like cash nor used by everyday
consumers to buy goods or services.

Today, the US Dollar is the world's primary foreign exchange reserve asset and SDRs may be
little used. Some nations, notably China and Russia (as well as the UN), favour increasing the
substance and function of the SDR.

Triffin dilemma

When the Special Drawing Right was created, as now, the US Dollar was the world's principal
foreign exchange reserve asset. But without a US deficit there would not have been enough
Dollars to sustain the degree of market liquidity a foreign exchange reserve asset requires.

A deficit is necessary for the United States to supply world demand for its Dollars, but such a
deficit will, in time, lessen the value of the Dollar and endanger the entire system. Known as the
Triffin dilemma, it was this problem that the creators of the SDR sought to mitigate.

So, in order to supply world demand for a foreign exchange reserve asset that had sufficient
market liquidity and simultaneously prevent any future crisis of confidence in the value of the US
Dollar, the International Monetary Fund created a "synthetic reserve asset", the Special Drawing
Right.

The role of the SDR

The SDR was created by the IMF in 1969 to support the Bretton Woods fixed exchange rate
system. A country participating in this system needed official reserves—government or central
bank holdings of gold and widely accepted foreign currencies—that could be used to purchase
the domestic currency in foreign exchange markets, as required to maintain its exchange rate.
But the international supply of two key reserve assets—gold and the U.S. dollar—proved
inadequate for supporting the expansion of world trade and financial development that was
taking place. Therefore, the international community decided to create a new international
reserve asset under the auspices of the IMF.

However, only a few years later, the Bretton Woods system collapsed and the major currencies
shifted to a floating exchange rate regime. In addition, the growth in international capital markets
facilitated borrowing by creditworthy governments. Both of these developments lessened the
need for SDRs.

The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the
freely usable currencies of IMF members. Holders of SDRs can obtain these currencies in
exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges
between members; and second, by the IMF designating members with strong external positions
to purchase SDRs from members with weak external positions. In addition to its role as a
supplementary reserve asset, the SDR, serves as the unit of account of the IMF and some other
international organizations.

Basket of currencies determines the value of the SDR

The value of the SDR was initially defined as equivalent to 0.888671 grams of fine gold—which,
at the time, was also equivalent to one U.S. dollar. After the collapse of the Bretton Woods
system in 1973, however, the SDR was redefined as a basket of currencies, today consisting of
the euro, Japanese yen, pound sterling, and U.S. dollar. The U.S. dollar-equivalent of the SDR
is posted daily on the IMF’s website. It is calculated as the sum of specific amounts of the four
basket currencies valued in U.S. dollars, on the basis of exchange rates quoted at noon each
day in the London market.

The basket composition is reviewed every five years by the Executive Board to ensure that it
reflects the relative importance of currencies in the world’s trading and financial systems. Back
in November 2010, the International Monetary Fund adjusted the valuation of its Special
Drawing Rights. It contains the four major currencies- the USD, the Euro, the Yen and the
British Pound. In the just released re-weighting, the SDR contains these currencies in following
ratios – USD at 41.9% dropping from 44%, the EUR at 37.4 %, rising from 34 %, the JPY
at 9.4% falling from 11% and the GBP at 11.3%. Both the Dollar and the Yen lost some of their
respective shares to the Euro, which is clearly gaining in importance. This new composition of
the SDR went into effect on January 1 2011. The role of the Dollar was diminished, but some
feel that the IMF have not gone far enough and failed to include other currencies.

The SDR interest rate

The SDR interest rate provides the basis for calculating the interest charged to members on
regular (non-concessional) IMF loans, the interest paid to members on their SDR holdings and
charged on their SDR allocations, and the interest paid to members on a portion of their quota
subscriptions. The SDR interest rate is determined weekly and is based on a weighted average
of representative interest rates on short-term debt in the money markets of the SDR basket
currencies.

SDR allocations to IMF members

Under its Articles of Agreement, the IMF may allocate SDRs to members in proportion to their
IMF quotas. Such an allocation provides each member with an asset (SDR holdings) and an
equivalent liability (SDR allocation). If a member’s SDR holdings rise above its allocation, it
earns interest on the excess; conversely, if it holds fewer SDRs than allocated, it pays interest
on the shortfall.

There are two kinds of allocations:

General allocations of SDRs. General allocations have to be based on a long-term global

need to supplement existing reserve assets. Decisions to allocate SDRs have been made three
times. The first allocation was for a total amount of SDR 9.3 billion, distributed in 1970-72 in
yearly installments. The second allocation, for SDR 12.1 billion, was distributed in 1979–81 in
yearly installments.

The third general allocation was approved on August 7, 2009 for an amount of SDR 161.2 billion
and took place on August 28, 2009. The allocation increased simultaneously members’ SDR
holdings and their cumulative SDR allocations by about 74.13 percent of their quota.

Special allocations of SDRs. A proposal for a special one-time allocation of SDRs was
approved by the IMF’s Board of Governors in September 1997 through the proposed Fourth
Amendment of the Articles of Agreement. Its intent is to enable all members of the IMF to
participate in the SDR system on an equitable basis and correct for the fact that countries that
joined the Fund after 1981—more than one-fifth of the current IMF membership—had never
received an SDR allocation.

The Fourth Amendment became effective for all members on August 10, 2009 when the Fund
certified that at least three-fifths of the IMF membership (112 members) with 85 percent of the
total voting power accepted it. On August 5, 2009, the United States joined 133 other members
in supporting the Amendment. The special allocation was implemented on September 9, 2009.
It increased members' cumulative SDR allocations by SDR 21.5 billion using a common
benchmark ratio as described in the amendment.

Buying and selling SDRs

IMF members often need to buy SDRs to discharge obligations to the IMF, or they may wish to
sell SDRs in order to adjust the composition of their reserves. The IMF acts as an intermediary
between members and prescribed holders to ensure that SDRs can be exchanged for freely
usable currencies. For more than two decades, the SDR market has functioned through
voluntary trading arrangements. Under these arrangements a number of members and one
prescribed holder have volunteered to buy or sell SDRs within limits defined by their respective
arrangements. Following the 2009 SDR allocations, the number and size of the voluntary
arrangements has been expanded to ensure continued liquidity of the voluntary SDR market.

In the event that there is insufficient capacity under the voluntary trading arrangements, the
Fund can activate the designation mechanism. Under this mechanism, members with
sufficiently strong external positions are designated by the Fund to buy SDRs with freely usable
currencies up to certain amounts from members with weak external positions. This arrangement
serves as a backstop to guarantee the liquidity and the reserve asset character of the SDR.
JUST as Special Drawing Rights (SDRs) were originally created to address a shortcoming of
the Bretton Woods system, so they are attractive again because they can help patch some of
the manifest failures of the reigning financial system. But that system has been failing
developing countries for a long time, and allocations of SDRs cannot substitute for the
fundamental reforms required to create a financial system that is just and sound for the entire
world. But SDRs can be a part of those reforms, specifically the repair of the distorted and
inefficient global reserve system.

A number of proposals have been made for how the global reserve system can be refashioned
so as to avoid the seemingly inevitable distortions resulting from reliance on one dominant world
currency (the US dollar). These distortions include the essential freezing of massive amounts of
dollars - potential development resources - as countries like China 'self-insure' against future
crises by building up their reserves. This self-protection has resulted in a massive accumulation
of US dollar reserves, amounting to $3.7 trillion across all developing countries in 2007
(Commission of Experts, 2009). These reserves are in essence a transfer of resources, at very
low interest rates, from developing countries to the industrial countries, especially the US, which
issue the reserve currencies. While the chief source of emergency finance available to
developing countries during times of crises is the International Monetary Fund (IMF), many
prefer low-return investments to the imposed, and often harmful, conditions of IMF loans.

Most of the proposals for reform of the global reserve system focus on the creation of a new
dedicated international currency for reserves, to avert the distortions created by reliance on
national currencies. The June UN Conference on the World Financial and Economic Crisis and
Its Impact on Development took a potentially important step by 'acknowledging' the calls for
such reform.

The calls by many States have been acknowledged for further study of the feasibility and
advisability of a more efficient reserve system, including the possible function of SDRs in any
such system and the complementary roles that could be played by various regional
arrangements.'

This is a concrete indication of momentum towards addressing the shortcomings of the current
reserve system. It could be used as a starting point for pushing relevant discussions in
international fora.

Outlook of SDR:

If the IMF were to become entirely SDR-based, SDRs would replace quotas and the emergency
borrowing mechanisms (the General and New Arrangements to Borrow) as the single source of
funding for the IMF. Countries with surplus reserves would be allowed - indeed, encouraged - to
convert their reserves to SDRs. This would allow countries like China to decrease the
percentage of their reserve holdings in dollars, thereby creating a healthier distribution of risks.
A 'substitution mechanism' based on proposals within the IMF to deal with earlier instances of
dollar weakness could be devised. Under it, 'the IMF would issue interest-bearing certificates
denominated in SDRs against dollar reserves handed over by central banks at the market
exchange rate, and invest these reserves in interest-bearing United States treasury bills and
bonds. The operation would not affect the total volume of international reserves but its
composition - thus no "inflation" fears. Countries can use these certificates to settle international
payments or to acquire reserve currencies. The substitution would result in a withdrawal of a
large stock of dollar reserves from the market and put them into IMF coffers. It would eliminate
the risk of monetary turmoil that could result from a potential widespread unloading of dollar
reserves by central banks.' (Aky�z, 2009)

Recommendations

* SDRs should be allocated by the IMF regularly, perhaps annually, in times of financial crisis.
To do this, the IMF's Articles of Agreement would need to be amended.

* Special, targeted allocations of SDRs should be made on the basis of need rather than quota,
or to categories of IMF members, for example to those eligible to borrow from the Extended
Credit Facility.

* Wealthy countries should transfer surplus SDRs directly to those with greater need for the
resources, and the IMF should facilitate these transfers without itself taking charge of the funds.
Such transactions should be conducted transparently.

* The costs of converting SDRs should be eliminated for the most vulnerable developing
countries, or subsidised by other IMF funds, such as the profits realised from the sale of IMF
gold.

* A second category of SDRs - temporary or reversible - should be created. It could be issued to

middle-income countries for temporary finance or reserve use, but they would have to be
replenished by a certain date, after which they would expire.

* The use of SDRs for a range of purposes, including for medium- or long-term development,
should be asserted and defended.

* Advocates and governments should build on the support expressed for the expanded scope
and use of SDRs at the UN Conference on the World Financial and Economic Crisis to push for
greater acceptance of their use with individual countries and with the UN.

* The United Nations and other agencies (e.g. the OECD, the IMF, the Financial Stability
Forum) should convene formal discussions on the crisis of the global reserve system and work
toward consensus on reforms that would eliminate dependence on the US dollar and develop a
new global reserve unit not tied to any single country.                                           

The above is an edited extract from the paper 'Fruits of the Crisis: Leveraging the Financial &
Economic Crisis of 2008-2009 to Secure New Resources for Development and Reform the
Global Reserve System' (January 2010).
The Bretton Woods system of monetary management established the rules for commercial and financial
relations among the world's major industrial states in the mid 20th century. The Bretton Woods system
was the first example of a fully negotiated monetary order intended to govern monetary relations among
independent nation-states.

Preparing to rebuild the international economic system as World War II was still raging, 730 delegates
from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire,
United States, for the United Nations Monetary and Financial Conference. The delegates deliberated
upon and signed the Bretton Woods Agreements during the first three weeks of July 1944.

Setting up a system of rules, institutions, and procedures to regulate the international monetary system,
the planners at Bretton Woods established the International Monetary Fund (IMF) and the International
Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. These
organizations became operational in 1945 after a sufficient number of countries had ratified the
agreement.

The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary
policy that maintained the exchange rate by tying its currency to the U.S. dollar and the ability of the IMF
to bridge temporary imbalances of payments.

On August 15, 1971, the United States unilaterally terminated convertibility of the dollar to gold. As a
result, "[t]he Bretton Woods system officially ended and the dollar became fully 'fiat currency,' backed by
nothing but the promise of the federal government."[1] This action, referred to as the Nixon shock, created
the situation in which the United States dollar became the sole backing of currencies and a reserve
currency for the member states.

The Triffin dilemma (less commonly the Triffin paradox) is the observation that when a
national currency also serves as an international reserve currency (as the US dollar does today),
there are fundamental conflicts of interest between short-term domestic and long-term
international economic objectives. This dilemma was first identified by Belgian-American
economist Robert Triffin in the 1960s, who pointed out that the country issuing the global
reserve currency must be willing to run large trade deficits in order to supply the world with
enough of its currency to fulfill world demand for foreign exchange reserves.

The use of a national currency as global reserve currency leads to a tension between national
monetary policy and global monetary policy. This is reflected in fundamental imbalances in the
balance of payments, specifically the current account: some goals require an overall flow of
dollars out of the United States, while others require an overall flow of dollars in to the United
States. Currency inflows and outflows of equal magnitudes cannot both happen at once.

The Triffin dilemma is usually used to articulate the problems with the US dollar's role as the
reserve currency under the Bretton Woods system, or more generally of using a national
currency as an international reserve currency.