Special Drawing Rights Essay

The special drawing right (SDR) was created by the International Monetary Fund (IMF) in 1969 as an artificial international reserve asset. The SDR was created as a unit of account involving transactions of the IMF. At the time it was created, its gold value was the same as that of the U.S. dollar. SDR was introduced to compete with the U.S. dollar as an internationally accepted store of wealth. Its value is based on a simplified basket of several major currencies. However, since the introduction of the euro, the basket of currencies used to value SDRs consists of only the U.S. dollar, euro, Japanese yen, and British pound.

Under the Bretton Woods system of fixed exchange rates, a country with a deficit balance of payments account would settle its accounts by giving up assets or claims to foreign assets. This is referred to as an official reserve transaction. Such a transaction would lead to a transfer of ownership of gold and convertible foreign currencies like the U.S. dollar. The Bretton Woods system also allowed countries to utilize their official reserves to purchase their domestic currencies when such currencies depreciate in the foreign exchange market. The two key reserve assets at the time were gold and the U.S. dollar. The mechanism for boosting reserves depended on the United States’ running a balance of payments deficit. By around 1969, the supply of gold and U.S. dollars was inadequate relative to the volume of international trade and commerce. This shortage of reserve assets was the motivation for the creation of the SDR.

When the Bretton Woods system collapsed, the SDR became a unit of account in transactions involving the IMF. Moreover, several international and regional institutions use the SDR as a unit of account. The SDR is not a currency in the true sense of the word because it is not a liability of the IMF that issues it. Many countries around the world peg their currencies to the SDR. There is a movement within the international private/commercial sector to issue SDR-denominated deposits in commercial banks. The focus on SDR is based on the fact that its value is not as volatile as that of many international vehicle currencies.

The Articles of Agreement of the IMF define the allocation of SDRs based on the quota of each member country with the IMF. The “net cumulative allocation” is the cumulative total holdings of SDRs allocated to a country. A country is expected to draw down its allocation of SDRs when it faces a balance of payments difficulty. SDRs can also be utilized to supplement the reserve holdings of a country. If a country draws upon its allocation of SDRs, it can exchange the SDR with foreign governments for their currencies to boost its reserves. Each member of the IMF is obligated to accept SDRs in exchange for its currency up to three times its net cumulative allocation. Sometimes the IMF can identify member countries with strong external positions to purchase SDRs from weak members in an attempt to help the latter.

The allocation of the SDR given to each member country translates to an acquisition of a costless asset because interest is neither paid nor earned. However, if a member holds SDR above its allocation, interest is earned on the excess. On the other hand, if a member holds SDR below its allocation, interest is paid on the shortfall.

When the SDR was introduced in 1969, its value was set equal to US$1 or 0.888671 grams of fine gold. In July 1976, its value was calculated based on a weighted basket of 16 currencies. In January 1981, the value of the SDR was redefined as a weighted average of five currencies. With the introduction of the euro in 2001, the value of the SDR was redefined again as a weighted average of four currencies. The criteria for selecting the currencies in the basket include the usability of currencies in accordance with Article XXX (f ) of the IMF, and are also those issued by the member countries or unions whose exports of goods and services during a five-year period are adjudged to have the largest value. The weight assigned to each currency in the basket depends on the value of exports of goods and services and the amount of reserves denominated in the currency. The currency basket is reviewed every five years. The method used by the IMF to determine the weekly SDR interest rate is also based on a weighted average.

Bibliography:

  1. Geert Bekaert and Robert J. Hodrick, International Financial Management (Pearson Prentice Hall, 2009);
  2. International Monetary Fund, “Review of the Method of Valuation of the SDR,” www.imf.org (cited March 2009);
  3. International Monetary Fund, “Special Drawing Rights: A Factsheet,” www.imf.org (cited March 2009);
  4. Dhara M. Khambata, The Practice of Multinational Banking (Quorum, 1996);
  5. Michael Melvin, International Money & Finance (Pearson Addison-Wesley, 2004);
  6. Michael H. Moffett, Arthur I. Stonehill, and David K. Eiteman, Fundamentals of Multinational Finance (Pearson Addison-Wesley, 2008);
  7. Thomas J. O’Brien, International Financial Economics (Oxford University Press, 2006);
  8. Kenneth Pilbeam, International Finance (Palgrave Macmillan, 2006).

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