How the SDR Substitution Account will Facilitate US Foreign Debt Consolidation
By JC Collins
There are many reasons why the normalization of monetary policy will need to happen in the foreseeable future. This eventual increase in interest rates will be the turning point which sets off the next stage of the multilateral monetary transition. This is a transition which will address the balance of payments deficits and allow for the equal representation of the emerging economies.
The large accumulation of US denominated securities in the foreign exchange reserve accounts around the world needs to be reversed. This unwinding of the dollars primary reserve currency status must be leveraged against the losses associated with the depreciation of the dollar which will ensue as dollar demand decreases around the world.
Changes to the existing exchange rate regime will begin the process of dollar reserve substitution. This substitution, and diversification of reserves, will in all probability begin in Asia, as the ASEAN Economic Community (AEC) trade agreement begins on January 1, 2016. Whether the actual changes to the exchange rate regime begin on that date is debatable, but there is no question that a vast amount of policies and framework have been completed on an Asian Currency Unit to act as a basket of currencies which would facilitate this overall process.
In the post Meet the Asian Monetary Fund we explored the possibility that the reluctance of the US Congress to enact supporting legislation to the International Monetary Fund’s 2010 Quota and Governance Reforms could lead to the formation of a micro IMF in the version of the AMF.
This Asian Monetary Fund would be an evolution of the Chiang-Mai Initiative Multilateral, and would be subservient to the macro IMF mandates.
In addition, the post Introducing the Alternative SDR2 reviewed how the reluctance of the US on the 2010 reforms, along with the political pressure to minimize the Chinese renminbi’s inclusion into the SDR, could lead to the formation of a parallel SDR2 which would serve the purpose of an Asian Currency Unit for use in the AEC.
The complexity of this transition, and all its moving parts, are challenging to trend and analyze. But over time a pattern begins to emerge and the substitution and diversification of USD denominated reserves will need to happen in order for the larger multilateral mandates to unfold.
One of the accepted methods of substituting USD reserves is through the Substitution Account (SA) of the International Monetary Fund. This process would allow for central banks, such as the People’s Bank of China, to exchange dollar denominated reserves for SDR reserves. The SA account, and in turn the IMF itself, would become the largest holder of American foreign debt.
With such a high value of dollar holdings in the substitution account, the US would be pressured to maintain the value of the dollar in order to prevent the value of the substitution account from eroding. Under such a scenario the need to replace the dollar as the primary reserve currency becomes questionable. A strong dollar would eliminate the need for an alternative reserve asset.
The one issue which arises in this hypothetical construct is that the US needs the dollar to weaken against its major trading partners in order to increase exports. The balance of payments deficit which the US has accumulated over the last 70 years needs to be reversed. A similar reversal of China’s balance of payments surplus will also need to take place.
As such, the only way for the US to increase domestic jobs and lower its debt-to-GDP ratio is by depreciating the dollar and making American made goods cheaper to foreign buyers. This increase in exports will be great for America, but will erode the value of the dollar holdings in the SDR substitution account.
One plausible solution is for interest rates to increase. Any currency depreciation must not exceed interest differentials.
Allow me to explain.
The US is in a catch-22 of sorts. It needs to reduce the amount of dollar denominated securities which have accumulated in the foreign exchange reserve accounts around the world. This would reduce the huge trade deficit which has developed. Increased exports, as explained above, would accomplish this, but the US also has a responsibility to ensure that the value of the dollar holdings in the substitution account does not depreciate with the dollar’s exchange rate.
Along with the creation of the substitution account itself, the IMF could create a Substitution Account Reserve Fund. This fund would earn interest from the US on the dollar denominated holdings held in the main Substitution Account (SA). The SA Reserve Fund would hold this growing interest on deposit for the purpose of maintaining the dollar depreciation and interest differentials.
For the purpose of clarity, let’s assume that the depreciation of the dollar causes the value of the dollar holdings in the main SA to erode. The interest which has accumulated in the SA Reserve Fund could be transferred back into the SA to offset this loss.
In the event that the losses on the dollar holdings in the main Substitution Account exceeds what is available in the Substitution Account Reserve Fund, the Reserve Fund could borrow dollars from the IMF itself. This “loan” could be paid back with future interest which will accumulate in the Reserve Fund.
Such a framework would function over time as the interest rates and exchange rates of the US dollar fluctuate. Increases in the interest rate would offset losses from the depreciation of the dollar denominated holdings.
Taking this logic a step further, dollar holdings which depreciate against the SDR must be compensated by higher US interest rates. This would maintain the sustainability of both the Substitution Account Reserve Fund and the Substitution Account. The more the dollar depreciates, the higher the interest rate will have to go to compensate for the losses on the dollar holdings.
As stated, currency depreciation must not exceed the interest differentials. The interest integrated within the SA Reserve Fund can be based the 20 year bond yield rate. The 3 month bond yield rate would be preferable to Congress, but some negotiation can be expected on this matter.
It is even probable that IMF gold holdings, or the gold holdings of other central banks, may be used to offset losses on dollar holdings due to currency depreciation. The accumulation of gold by China could facilitate this process within an Asian Monetary Fund and SDR2 construct. The US would expect that countries with large dollar holdings would share in the losses of dollar depreciation. A transfer of gold from central banks to the IMF was explained in the posts China Gold Deposits to the IMF and Will China Transfer American Debt to the IMF.
Depending on the effectiveness of the framework described above, in time allocated SDR, which is SDR created by the IMF, would be consolidated with the SDR created by substitution. The merging of both would position the SDR to be accepted as the primary reserve asset. This process would also include the eventual merging of SDR1 and SDR2, as well as the Asian Monetary Fund with the International Monetary Fund, if such a strategy is in fact employed.
The United States should be leading this mandate before they lose further monetary ground to the emerging markets, such as China, and to a larger extent, BRICS. Now that Iran will also be joining the BRICS Development Bank, the comments of John Kerry regarding the USD losing its reserve status if the nuclear deal with Iran was not completed makes more sense.
The biggest challenge all players will face is how to prevent additional dollar reserve accumulation once the substitution account mandate begins. Deeper depreciation to the dollar outside of what interest rate increase differentials can manage would likely drag the international monetary system through additional hardships. This could even be a strategy which the US would leverage down the road to effect tangible influence upon regions and governments.
The devil is always in the details. – JC