And More Mischief About the SDR, RMB, and Gold
By JC Collins
When Managing Director of the International Monetary Fund Christine Lagarde gave the speech last year where she mentioned the number 7 numerous times, the internet caught fire with theories and analysis of what exactly was meant by the term “magic seven”. Contrary to popular opinion, it had very little to do with the occult, and more to do with the forthcoming composition changes to the SDR valuation.
The purpose and theme running through the Special Drawing Right composition is also directly connected to the ending of the Swiss franc peg to the EUR. But before we get into that let’s review some of the information and logic behind the analysis which we are going to review and present in this post.
The move away from the USD as the primary reserve currency used in the global financial system will be the largest change and transition in how the world functions in most of our lifetimes. The balance of payments system which supports the United States dollar is stricken with imbalances, as presented in the Triffin Paradox.
The Triffin Paradox thoroughly explains the challenges faced when one specific domestic currency is used as the global reserve currency. The amount of USD building in the foreign reserve accounts around the world creates domestic pressure on the USD, which in turn forces the US to print more currency, which then in turn promotes deficiencies and pressures on the exchange rate regime which supports the USD.
It is collectively agreed by all, including America itself, that the USD should be reduced in the foreign reserve accounts around the world, and something supra-sovereign to a domestic currency needs to be optimized as the international unit of account. The SDR of the International Monetary Fund is set to rise and take that crown, which will soon be vacated by the USD.
The reserve characteristics of the SDR create the opportunity to move away from the use of domestic currencies as primary reserve currencies. Currently the SDR basket composition is made up of four currencies, the USD, Japanese YEN, British GBP, and the EUR.
For the SDR to gain legitimacy as a global unit of account, the composition of the basket has to be expanded to include a more balanced representation from the largest economies. It is debatable whether China is now the largest economy on Earth, or the second largest, but either way the inclusion of the Chinese currency, RMB, in the SDR composition later this year is widely accepted as inevitable. This is covered, with expanded links, in the post The Redback Revolution.
The RMB is the seventh most traded currency in the world. So we can expect that if the SDR is going to include the Chinese currency, all which come before it will also be added to the basket as well.
There are a few metrics and standards which we can reference to define the top seven currencies in the world. For our purposes here, we will use the data of the Bank for International Settlements, as measured and segmented into the following categories:
• International Debt Securities – Currency Composition
• Global Foreign Exchange Market Turnover – Currency Composition
• Global Foreign Exchange Derivatives Market Turnover – Currency Composition
• Exports and Financial Inflows – Exporters
In all categories the following seven currencies dominate the top positions:
- USD – United States dollar
- EUR – European Union euro
- YEN – Japanese yen
- GBP – Great Britain pound
- CHF – Swiss franc
- CAD – Canadian dollar
- RMB – Chinese yuan
The top 4 make up the current composition of the SDR. With all the hype surrounding the RMB, and its internationalization for inclusion into the Special Drawing Right, the remaining 2 currencies have somewhat been forgotten.
In order for the Swiss franc to be considered for the SDR, which it would have to be based on the above metrics and conditions, it had to end the peg to the euro and free float like the ones above. This also means the RMB will end its managed peg to the USD in the coming months and become more market oriented before being added to the basket.
The legitimacy of the basket, and the SDR’s ability to stabilize both global liquidity and the new exchange rate regime, will require all 7 currencies listed above to be included.
The IMF has also expanded and improved the data reporting which is expected from its member countries. This is a vital component of the transition to a multilateral financial system structured around the SDR.
In a report presented to the G20 Finance Ministers and Central Bank Governors on September 11, 2014, the International Monetary Fund, the Bank for International Settlements, and the Financial Stability Board, reviewed, and dictated, the terms of improving the data gaps on foreign currency exposures.
This reduction in foreign currency risk is directly tied to the coming discussions around adjustments to the SDR basket, and the Sovereign Debt Restructuring Mechanism. The SDRM will address the growing sovereign debt crisis and allow for a re-allocation of SDR instruments under the Designation Mechanism.
The DM will be used in situations where the capacity in voluntary trading arrangements becomes insufficient. Member countries of the IMF who have strong external positions, being loaner nations, can purchase SDR’s with freely usable currencies, from members with week external positions, being borrower nations.
The use of substitution accounts will ensure that no exchange rate losses are incurred during the process. When we consider the large amount of USD in the foreign reserve accounts around the world, a sovereign debt which the US owes to China, among others, the use of a DM and SDRM methodology will only work if the above 7 currencies are included into the SDR composition to create the necessary stability and legitimacy.
The IMF has been developing the expectation amongst member countries that data reporting has to be improved. This week Canada was informed that it needed to improve data reporting and take further measures to address its overvalued home market. Back in January, Christine Lagarde traveled to China to discuss improvements to that countries data reporting.
A part of the report from the IMF, BIS, and FSB, stipulates that the availability of “appropriate high quality interest rate instruments” are to be maintained and developed. Proper data reporting will ensure “domestic assets exist with a well-defined interest rate”, which in turn will help reduce foreign currency exposures.
The report, which can be read here, was signed by the following:
IMF Representative – Christine lagarde
BIS Representative – Jaime Caruana
FSB Representative – Mark Carney
The progression towards the multilateral financial system is picking up momentum. With the announcement of the forthcoming Chinese payment system, CIPS, which we had previously covered here, and here, it is becoming increasingly challenging to deny the obvious truth in front of us.
The SDR seven will form the new basket composition, and perhaps, just perhaps, that is what Ms. Lagarde was attempting to communicate all along. Her reference to the “magic 7” is extremely similar to the term “magic circle” which was used in another official publication last year, when it was mentioned that the RMB would gain entry in the SDR magic circle. This was reviewed in the post The SDR Magic Circle. Here is a quote from the publication:
Chinese entry into the ‘magic circle’ of reserve currencies in the SDR, along with the other components (the dollar, euro, yen and sterling), has already been advanced by a ground-breaking decision announced this month by the UK Treasury. The British government will issue renminbi-denominated bonds, the first sovereign government to take such a step (apart from the Canadian province of British Columbia), and allow the proceeds to be held in the UK reserves managed by the Bank of England, breaking two long-held taboos for the UK authorities.
From this statement we can assume that the “other components” referenced are the other currencies which make up the magic 7, as presented above, and not just the 4 which were listed.
Those who still deny the reality of this multilateral transition to the international financial system are increasingly running out of logical and rational arguments. It is happening whether we agree with it or not. And the end of the Swiss franc peg is only the first of many market rattling events.
That just leaves gold. Here at POM we have considered two possibilities. One, gold is included directly into the basket at a specific percentage of the overall valuation. Second, gold could be used to partially support the 7 core SDR currencies, which would indirectly help bring stability to the asset.
Either way, big wheels are in motion. Recently Alasdair Macleod wrote a piece titled The New London Gold Fix and China. In it he explained how the four London fixing banks will be handing control over to the International Commodity Exchange on March 20, 2015. This means that the London gold market will become partially regulated. It also gives China the opportunity to dominate the gold market.
Taken in the context of our discussion, China would want to secure the gold market, or at least prevent manipulation of the gold market, before it ends the peg with the USD and partially supports the RMB with gold reserves. This supports our argument above that gold will not be directly included in the SDR composition.
And with all of that will come the announcement from China on their official gold reserves. These reserves will be used to both support the yuan and bring stability to the international financial system. A financial system which will still include the USD. – JC