How the SDR and Regional Reserve Funds Could Prevent Mayhem
By JC Collins
There is a growing uneasiness that competitive currency devaluations could become the norm in the months and years ahead as nations struggle and fight for the top spots in the global economy. This potential is real and would have prolonged and undesirable effects on the international financial system. Which is why there has been a multilateral framework being developed for years now.
This framework is being structured around the SDR of the International Monetary Fund and a multicurrency reserve system which will facilitate the creation of both regional currency units and regional reserve funds, with the IMF and SDR at the apex.
With both the G20 and the International Monetary Fund itself now calling for a broader use of the SDR in the international monetary system, it is worth reviewing some of the fundamentals around how such a framework would function.
The movement towards a more balanced and multilateral monetary architecture will be staggered and will take years. The recent implementation of the 2010 IMF Quota and Governance Reforms and the inclusion of the Chinese renminbi in the Special Drawing Right (SDR) composition are two straight-forward examples of such changes.
Other changes which we can expect in the coming months and years will consist of the following:
- A more IMF-centered macroeconomic policy.
- The piecemeal implementation of an SDR-based international reserve system.
- A realignment of the exchange rate regimes which govern the existing monetary framework.
- Capital account regulations will become broader with a focus on reserve adjustments.
- A sovereign debt restructuring mechanism will have to be put in place.
- Further reforms to the Bretton Woods Institutions to align with emerging institutions.
All of these mandates and adjustments will transform the existing monetary framework and build towards what is expected to be a more stable system. The use of regional reserve funds could also facilitate this restructuring and add a thicker layer of stability. There are some challenges though which could threaten the broader SDR use, and this is where a regional reserve fund concept would come into play.
Some of the challenges which are presented with using the SDR as the international reserve asset can be minimized, and perhaps even eliminated, by staggering the structure of the multilateral financial architecture.
In the post The Rise of the Regional Currency Units we reviewed some of these challenges. It is important to note that with regional reserve funds would come regional currency units. Which is why it is important to review and understand this concept.
One of the main challenges with using the SDR is how to capture and account for, both economically and socially, the wide diversity of culture and politics which span the globe. Lumping everything and anything into a one-size-fits-all composite will inevitably lead to bureaucratic bottlenecks and tense geopolitical situations which are not easily solved.
The ability of the International Monetary Fund to function as a central bank of the world with the responsibility of setting SDR reserve requirements and exchange rate arrangements is fraught with national and regional challenges for participating members.
So how does the monetary world deal with these challenges?
The implementation of the multilateral monetary framework will happen piecemeal and through staggered responses to financial crises. Some solutions will be sovereign based. Some solutions will be regional based. And some solutions will be international and multilateral based.
There will be a multilateral component to regional solutions and mandates as well, but they will be micro machinations of the larger macro methodologies which will be established through numerous macroprudential agreements and regulations.
As an example, in the post Meet the Asian Monetary Fund, we explored the transition of the Chiang Mai Initiative Multilateralization (CMIM) into a functioning Asian Monetary Fund which would serve as a micro-region based institution which would support the marco-international mandates and framework established by the IMF.
The AMF would be more apt and able to both respond and prevent any regional East Asian financial crisis than the IMF would be. The establishment of such regional monetary funds, whether in East Asian, North America, Africa, or Eurasia, will serve to bring a deeper and broader stability to the international monetary framework.
Let’s consider that each region and monetary fund has its own currency unit which acts as a micro basket of currencies, serving the same function as the macro SDR basket of currencies. These currency units can act as the first line of defense and response to potential monetary challenges.
The euro currency itself was first established as a currency unit, called the European Currency Unit (ECU), which was a basket of weighted regional currencies. Eventually the weights and valuations were locked and the actual euro currency was born from the framework of the ECU.
Equally so, the AMF will see the implementation of the Asian Currency Unit (ACU) which will be based on the same framework of the Asian Monetary Fund itself, which we reviewed in the above post.
The ACU will also likely facilitate the monetary requirements of the AEC trade agreement which came into effect on January 1, 2016 in East Asia.
The inclusion of the Chinese currency into the SDR composition, effective Oct 1, 2016, will give legitimacy and value to the ACU, as the RMB will be a functioning composite of both baskets.
As the ACU becomes more established, along with regional currency units in other parts of the world, such as Eurasia, future SDR compositions could be made up of regional currency units as opposed to domestic currencies, such as the USD, euro, and renminbi. This will facilitate the regional reserve fund concept.
The transition and evolution of all currency baskets, whether macro SDR or micro ACU, will also take place through a staggered process. Potentially both domestic currency and regional currency units could exist in the SDR simultaneously, thought the outlook would see the SDR structured on regional currencies themselves.
Like with the euro, each currency unit will eventually become an actual currency, which will, in turn, see the SDR itself become an actual currency in the future. As previously stated, this future macro-international currency will be called the bancor, as it was during the Bretton Woods negotiations of 1944.
The things to watch for, and trends to analyze in the coming months and years are the establishment and implementation of both regional monetary funds and currency units. The buildup of such frameworks will ultimately lead to the rise of a true world central bank.
The SDR, though able to handle short-term solutions to sovereign debt crisis and financial turmoil based on balance of payments deficits, will no doubt require further adjustments and evolution in order to facilitate and respond to the challenges of a multilateral monetary framework.
Watch for the early signs of SDR recommendations as the solution to the building financial volatility which is spreading through all segments of the international monetary system, including exchange rates, foreign exchange reserves, and liquidity. The call by the G20 for a broader use of the SDR is the first official statements of this sort.
Just like it took years for the world to transition from the British pound reserve system to the USD reserve system, it will take years for this transition to the supra-sovereign SDR reserve system to complete. We are only in the early stages of this transition. – JC