SDR Replication within the Bank for International Settlements

Economics, Premium POM

More Fed Rate Increases and Changing Exchange Rates

By JC Collins

With a June interest rate increase on the agenda we are once again going to experience the subsequent volatility which followed the last Federal Reserve hike.  The level of this volatility will be difficult to predict but it is certain that there will be movement in the worlds markets.

Most analysts and larger institutions are anticipating some level of liquidity crisis in the coming months.  The depth and broadness of this crisis will depend on a wide array of factors and monetary reforms which have been taking place.

China has been building the services and infrastructure to support an increase in renminbi off-shore liquidity.  The growth of this liquidity market is meant to offset a contraction in US dollar liquidity as more of the multi-currency reserve framework is implemented.

The valuation of gold will be dictated by the smoothness of this transition and shifting from USD liquidity to RMB liquidity.  Misalignments on interest rate increases and alternative liquidity growth will cause additional spikes in the price of gold.  But gold could also experience downward pressure if the transition moves forward with less volatility than expected.

It has always been my contention that the explosion in RMB liquidity this year would cause further decreases to the valuation of gold, but let’s see what happens throughout the summer months.  The effective date of the new SDR weighting, which now includes the RMB, will be in October.  One of the mandates of the G20 is the development of a broader use of the SDR to specifically address a future liquidity crisis.

Unfortunately more information on this process has not been made available and we are left to speculate based on policy papers and working group discussions which have been previously published.

One such policy paper is titled Avoiding the Next Liquidity Crunch: How the G20 Must Support Monetary Corporation to Increase Resilience to Crisis, which was published by Global Economic Governance in October of 2015.

The following is taken from that publication:

THE G20 SHOULD:

  1. Refocus its political agenda on financial and monetary stability measures and support reform of the international financial architecture beyond merely improving the IMF quotas;

 

  1. Prioritize reforming the Fund’s SDR Department as a central monetary system to exchange both traditional global currencies and also new emerging currencies, to serve as connection between regional and bilateral currency swap networks;

 

  1. Establish guidance for the reform of the SDR Department at the IMF, including recognizing the role of emerging countries’ currencies in the system and considering frequent new allocations or cancellations of SDRs, according to the global needs of liquidity;

 

  1. Facilitate a “coalition of willing” among the largest emerging countries, concerned advanced economies and other developing countries, with the Bank for International Settlements (BIS) as manager, to replicate the institutional design of the Fund’s SDR Department.

Most of those points will not be surprising to POM readers, but what I found extremely interesting is item four, which references the Bank for International Settlements in a manager role over a replication of the SDR framework with the IMF.

We have previously explored the possibility of the BIS acting as a clearing house for the Special Drawing Right, but the concept of the BIS replicating the actual SDR methodology is something which I haven’t encountered before.

One of the only publications from the BIS regarding the SDR is titled The Role of the SDR Denominated Securities in Official and Private Portfolios.  This document contains a lot of valuable information but doesn’t discuss a replication of the SDR process and function.

But what does come to mind is the recent move by the People’s Bank of China to partially peg the renminbi to a basket of currencies within the BIS.  A multiple pegging framework between the USD, the SDR, and a BIS basket could very well provide the renminbi with the foundational strength needed to broaden liquidity and provide and alternate reserve opportunity to the USD.

Some of this information was covered in the POM post titled China Just Ended the Dollar Peg (…for the most part) – Rise of Multilateral Exchange Rates & the Feds Rate Hike.  It is worth the reader revisiting this information when considering the material provided in this post.

There is no doubt that large monetary changes are afoot.  But how those changes will be implemented is still largely unknown outside of the movement towards a broader role for the SDR.  The shifting of liquidity between the US dollar and the Chinese renminbi while attempting to position an alternative international reserve asset is the fundamental challenge of our monetary and financial age.  – JC