Understanding the Role of the 3 SDR Types within the International Monetary Transformation
By JC Collins
Outside of the new SDR composition there was one other news story that went largely unnoticed last week. The New York branch of the Bank of China became a clearing center for renminbi trading. This marks the first American based clearing center for the Chinese currency and is directly related to the advancement of the RMB in the global monetary framework. This move is also an indication that all the major players, including the United States, are supporting and moving forward with the broader internationalization of the renminbi.
This is important because the renminbi will allow for an enhanced and more balanced SDR role in the international monetary system. One example of this re-balancing is the new SDR interest rate which will be announced on October 7th. It is expected that the RMB’s inclusion in the SDR will allow for a moderate SDR interest rate increase. Such an increase will make SDR denominated securities more attractive.
Over the next six months the IMF will be completing further studies and research on the role of the SDR in the international monetary system. The focus will be on the three types of SDR which will be used moving forward. This Triad SDR will consist of the following:
- O-SDR – These are Official SDR allocations and quota amounts which are assigned to member nations. The forthcoming use of substitution accounts to diversify foreign exchange reserves will utilize O-SDR and new allocations which will be created through this substitution. Quota amounts will also change modestly in the coming years but the real changes will take place in new allocations through reserve substitutions.
- M-SDR – The Market SDR will contribute to the validation of the SDR as a supra-sovereign asset which can be used to re-balance the international monetary system. The initial issuance of SDR denominated bonds by the World Bank in China will soon be followed up with additional and larger issuances. M-SDR will also be reflective of indexes, such as crude and other commodities, which will be denominated in SDR in the not too distant future.
- R-SDR – The reserve function of the SDR as a unit of account is the larger goal and objective which the other two SDR types are contributing. The need to shift away from the credit-based national currency methodology which has dominated the existing monetary system for decades is a must for re-balancing to take place.
The wide use of the USD as the primary reserve currency is the main problem with the existing framework. The massive accumulation of USD in the foreign exchange reserve accounts of central banks around the world is the number one cause of the systemic imbalances which have developed.
As mentioned above, the use of substitution accounts will facilitate a diversification of these reserves. But such diversification will require that IMF member nations place a percentage of their foreign exchange reserves under the direct management of the fund.
Centralized management of foreign exchange reserves within the International Monetary Fund will add further stability to the international system and allow for a more coordinated response in time of financial crisis.
The centralized management of reserves within the IMF will also provide additional momentum for the broader development of SDR markets and further enhance its role within the monetary system. Outside of direct substitution, the IMF can also establish an open-ended SDR denominated fund which will function as a market driver for the transference of member currencies in and out of SDR assets.
This will develop deeper SDR liquidity which will in turn contribute to additional allocations of O-SDR and new issuance of M-SDR. Both the O-SDR and M-SDR will build the case for replacing existing reserves with R-SDR as a unit of account.
Come the end of March next year the International Monetary Fund will be making further recommendations to the Executive Board on the next phase of SDR implementation and reforming of the international monetary system. These recommendations will be focused on the broader use of all three SDR types.
The R-SDR, or reserve SDR used as a unit of account, is the core objective which the IMF Executive Board will be reviewing. The development of this strategy will take years with completion milestones marking the transition. The implementation of the new SDR composition on October 1st marks one of those milestones. The issuance of SDR denominated bonds a few months ago marks another milestone. There is sure to be additional milestones this coming spring and in the months and years ahead. – JC