How the IMF and China will transform the SDR
By JC Collins
As a follow up to the post yesterday titled China and Greenspan on a New Gold Standard it is worth exploring in more detail some of the fundamentals of such a new monetary framework. It is evident that a broader use of the SDR will be mandated in the coming months. This is now beyond dispute as the official communications from the G20, IMF, as well as central banks and other international institutions, are all openly discussing an expanded SDR.
The People’s Bank of China has even announced their intention to issue SDR denominated bonds and create an SDR-based borrowing platform. This process is being facilitated by the internationalization of the renminbi and the growth of its liquidity market. It has also been recently announced that an American bank will be purchasing 250 billion renminbi.
All of this builds an undeniable case for the SDR multilateral framework which will be supported by a continuation of the USD in its reserve capacity. The RMB will compliment this process by providing an alternative reserve asset alongside the dollar, and additional liquidity in the event of a deeper international financial crisis.
The SDR will provide the planned penultimate response to any developing crisis and the SDRM (Sovereign Debt Restructuring Mechanism) will facilitate debt challenges which have been allowed to grow and fester.
The concept of adding gold to the weighting of the SDR was first discussed here on POM back in September of 2014. Since that time much has transpired which provides additional support to the idea. The accumulation of gold by China and other nations with large trade surpluses, along with the statements by Alan Greenspan, and the implementation of the Shanghai Gold Exchange, would suggest that gold is being positioned to be re-introduced into the international monetary system.
Let’s review some of the challenges with expanding the use of the SDR and follow the logic through to the inclusion of gold into the composition weighting.
The SDR in its present incantation is not a means of exchange. Becoming a supra-sovereign reserve currency will require the SDR to develop a store of value function. This can be created through the building of an SDR liquid market. This secondary market would remove the existing restrictions on the SDR and allow it to become a liquid convertible asset.
Development of the SDR bond market would facilitate this process. China issuing SDR denominated bonds and implementing an SDR-based borrowing platform would establish such a liquid market. Adding a gold weighting would further this development.
The benefits of adding gold to the SDR follows monetary logic. The first and most obvious benefit is that it addresses the growing demand to re-introduce gold to the existing USD-based international monetary system. This re-introduction, if structured correctly, would provide a counter-balance to the forthcoming USD depreciation based on the trend of inverse valuations. Such inverse depreciation/appreciation would help offset dollar losses with SDR claims. This will become clearer below.
Some of the challenges associated with adding gold to the SDR also follows monetary logic. A clearing house would need to be made available in order to provide gold when SDR claims are put forward. One method of addressing this challenge is to make gold claims residual, meaning gold could only be claimed when none of the other currencies in the SDR composition are available.
This would amount to a gold inclusion in the SDR for valuation purposes only with rights to sell SDR for gold restricted. Such a mandate would also reduce strain on gold reserves during periods of economic crisis and exchange rate volatility.
Gold is also susceptible to bubbles during these periods of volatility, which the financial crisis of 2008 has shown. Using gold in the SDR for valuation purposes only would minimize such bubbles.
Another method of addressing some of these challenges with including gold in the SDR composition is to maintain the weighting around 5%, or maybe 10%. Based on the inverse relationship between the USD and gold, any losses in SDR valuation attributed to dollar depreciation can be offset with an appreciation in the value of gold. Maintaining a proportionate weighting for gold within the SDR would minimize the risk of a gold bubble forming.
Bubbles don’t contribute to financial and economic stability, and while many would be delighted with sudden and dramatic increases in the valuation of gold, the negative effects on the international financial system when it reverses would be destructive.
The gold reserves belonging to the International Monetary Fund could be used to back SDR claims. This is an important aspect of this monetary transformation as nations with large trade surpluses, which would include China and other emerging nations, would be required to purchase SDR with their gold reserves.
It is not coincidental that these emerging markets have been the ones accumulating large amounts of gold in the years since the financial crisis. The reason why China and others have been accumulating gold is explained by following this monetary logic, which I first proposed in the post China Gold Deposits to the IMF.
The transfer of gold reserves to the IMF in exchange for SDR would align with China’s announcement of issuing SDR denominated bonds and creating an SDR-based borrowing platform. The pieces of this monetary puzzle are beginning to fit together.
This arrangement would lockup the gold reserves belonging to the IMF along with those subsequently placed on deposit, or exchanged, with the IMF for SDR. It is unlikely that the IMF would act as the clearing house for SDR claims on gold. It is more likely that selling SDR for gold would be restricted, as explained above, to minimize the strain placed on IMF gold reserves.
The Bank for International Settlements has also expressed intent to serve as a clearing house for SDR transactions as well as offering SDR denominated products and services. I do not expect that the BIS would take on gold reserves to support the whole of the SDR framework, but they could, like China, provide some support through the issuance of SDR bonds and even transferring their own gold reserves to the IMF.
There is a new SDR weighting which is effective this October. This composition, which includes the renminbi, looks like this:
A developing financial crisis, such as the recent response to the BREXIT vote, could provide the pretext and justification for a broader use of the SDR with the inclusion of gold in the composition. This would amount to a new gold standard as suggested by Alan Greenspan and others. This SDR weighting could potentially look like this:
Last year I wrote about the potential of gold depreciating further as RMB liquidity expanded internationally and its role as an alternative reserve asset to the USD became apparent. This is still possible when we consider the dual alternatives which both the SDR and RMB would provide.
There are obviously different scenarios which should be considered. One would mean the inclusion of gold in the SDR and the other would not. Either path could potentially see a depreciation or appreciation with gold. But if gold is not included it would be probable that its valuation would decrease as SDR and RMB liquidity alternatives expanded internationally. This could potentially even transform the inverse relationship between the dollar and gold.
In the event that gold is included and the USD depreciates we could see upward valuations. It is my prediction that the dollar will depreciate by 20% to 30% in the coming 12 to 18 months. This depreciation will facilitate an increase in American exports and massive job creation.
Nations with trade deficits, like the US, will experience depreciation to increase exports and decrease imports, while nations with trade surpluses, like China, will experience currency appreciation to decrease exports and increase imports. This appreciation of the renminbi would cause an equal appreciation in the SDR as the dollar depreciated. Whether gold, and its inverse relationship with the dollar, would offset these losses more effectively is not known. – JC
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