Understanding O-SDR, M-SDR, R-SDR and Substitution Accounts
By JC Collins
Moving forward the US dollar will begin to experience depreciation bouts which will eventually see the valuation drop by 20% to 30% against the currencies of America’s largest trading partners. This strategy by western monetary authorities, in alignment with international monetary authorities, will begin the process of managing the large amount of debt which has accumulated from the dollars role as the primary international reserve asset.
The abstract nature of this monetary transformation needs to be viewed and considered from multiple angles. Most nations have accumulated large volumes of US Treasuries in the foreign exchange reserve accounts of their central banks. Emerging economies, such as China’s, have taken the bulk of this US sovereign debt and exported inflation.
The demand for the dollar as the primary reserve asset has been driven by a lack of alternatives, such as the SDR will gradually provide. This dollar demand has maintained the value of the US currency and forced a contraction of American manufacturing and exporting. Higher dollar means higher cost for American made goods. It is important to understand that any depreciation of the dollar will equate to a depreciation of the investment which foreign central banks made by accumulating large amounts of US Treasuries.
In this situation lays the problem for the rest of the world. The diversification away from the US dollar needs to take place but the process which is required to do so carries substantial risk and potential loss of valuation to investments. But the situation cannot remain as imbalances in the international monetary system continue to deepen and cause depreciation and a contraction of global growth.
Once the US dollar depreciates American made goods will become more affordable and exporting will increase as factories fire up and domestic jobs increase. This increase in exports will contribute to GDP growth and lower the debt-to GDP level.
This phased depreciation of the US dollar will create instability, as it did in the 1970’s, and lend support to the phased implementation of the SDR as both a market instrument and unit of account. The catch-22 predicament is that it needs to depreciate in order to repair the domestic economy and financial markets but cannot depreciate because the international demand has not yet reversed enough to allow for the larger diversification of foreign exchange reserves.
In the environment of a weakening US dollar, SDR denominated assets will provide investors with a level of stability. The SDR itself now needs to be discussed in three segments. One is the O-SDR which refers to the official SDR as it has been maintained through allocation by the International Monetary Fund. Another is the M-SDR which is a reference to the market oriented SDR denominated financial products, such as the recent SDR bonds issued by the World Bank in the Chinese market. The last segment is the R-SDR, which will reflect the reserve function and unit of account characteristics of the SDR as it further broadens and begins to replace domestic currency accumulation in the foreign exchange reserve accounts of central banks around the world.
Central banks will have the opportunity to exchange USD denominated foreign exchange reserves with new allocations of O-SDR through the use of IMF substitution accounts. The purpose of the substitution account will be facilitating the exchange of US treasuries without central banks taking the loss on further depreciation.
Such a set up will place the IMF in the role of underwriter on international losses due to USD depreciation. These losses will be offset by future SDR interest payments as the use of all three forms of SDR are implemented and broadened.
It is important to understand that the USD is not going to collapse or go away. Its function as the primary international reserve asset is shifting to become more domestic focused again, as it was before the Bretton Woods arrangement. This will see America slowly begin to balance its trade deficit and move towards equilibrium between deficit and surplus.
China will also move towards this equilibrium between deficit and surplus, but from the other end of the spectrum as it corrects its large trade surpluses.
The role of the Federal Reserve will also transform from that of an institution supporting the primary reserve currency and international economy to one managing the growth of a domestic currency and economy. Such legislation and debates surrounding this transformation of the Federal Reserve such be expected in the future.
The accumulation of O-SDR within the foreign exchange reserve accounts of the world’s central banks will provide the necessary platform for the development of the R-SDR as the international unit of account. This process will take years and both the USD and Chinese RMB will provide the framework liquidity from which the supra-sovereign R-SDR liquidity will develop. – JC