Dreaming of SDRs

Why the IMF's long dreamed-of Special Drawing Rights will always be the currency of the future.

In March 2009, in the midst of the financial crisis, the normally circumspect governor of China's central bank made waves. In a speech published on the bank's website, Zhou Xiaochuan argued that the world needed a "super-sovereign reserve currency" to be managed by the International Monetary Fund (IMF). The influential banker said that an IMF-issued currency would serve as a "light in the tunnel for the reform of the international monetary system."

Zhou's call was widely interpreted as a jab at the U.S. dollar and the privileges that the United States retains as the issuer of the world's leading reserve currency. The U.S. Treasury Department dutifully pushed back against the suggestion that the dollar should lose its preeminence. "I think the dollar remains the world's standard reserve currency. I think that's likely to continue for a long period of time," said Treasury Secretary Timothy Geithner. For his part, President Barack Obama insisted that the dollar was "extraordinarily strong."

Zhou's suggestion was, in many respects, less remarkable than it seemed. The IMF already has in place the "super-sovereign" currency that he envisioned. Moreover, it is stated IMF policy that this currency -- the awkwardly titled Special Drawing Rights (SDRs) -- should become the world's leading reserve currency. Zhou's suggestion appeared revolutionary only because of the convoluted history of this would-be global currency.

The idea of an IMF currency emerged in the early 1960s. At that time, a group of leading economists -- notably Robert Triffin -- was alarmed at what it perceived as a looming liquidity shortage. The Bretton Woods system established at the end of World War II acknowledged the dominant place of the dollar, but it pegged the dollar to gold. Triffin argued that this limited the dollar's ability to serve as an effective reserve currency. The more dollars the United States pushed into the system, the more doubt there would be about its ability to back the dollar with gold. As John Williamson of the Peterson Institute for International Economics describes it, "The Triffin dilemma posited that the world therefore confronted a choice between running short of liquidity and undermining confidence in the dollar, which was destined sooner or later to produce a crisis."

The solution that financial policymakers hit upon was to have the IMF create a new international reserve currency: the SDR. This new currency's value would be determined by a basket of widely traded currencies, basically hedging against the risk inherent in any one currency. At the time, this basket was comprised of the dollar, the yen, the pound, the franc, and the Deutsche mark (the last two were subsequently subsumed by the euro). The first SDRs -- more than 9 billion of them -- were issued beginning in January 1970. But just as SDRs were appearing, the very reason for their existence seemed to disappear. In 1971, U.S. President Richard Nixon's administration broke the link between the dollar and gold. Just like that, Triffin's famous dilemma ceased to be a dilemma, or at least an acute one. Freed from gold, the United States was able to produce as many dollars as it liked, enough to satisfy the world's demand for reserve holdings.

The SDR, which IMF economists had expected to become a central feature of the world's monetary system, instead became a bit player. Today, even after a major new issuance in 2009, SDRs constitute less than 4 percent of global reserves and are used almost exclusively in transactions between sovereign governments and the IMF itself.

But as Zhou's speech suggests, the idea of the SDR assuming a more prominent role persists. Liquidity may not be the problem that policymakers feared in the 1960s, but a dollar-dominated system has other perceived disadvantages. Plenty of observers believe that the dollar's position gives the United States an unfair economic advantage. French Finance Minister Valéry Giscard d'Estaing famously declared that the United States enjoyed an "exorbitant privilege" by issuing the world's de facto reserve currency. In economics parlance, that advantage is usually labeled "seigniorage." The significance of this advantage is hotly debated by economists, and some even argue that the United States suffers from the dollar's preeminence (primarily because it makes exports less competitive).  

A more pronounced concern is that the dollar's widespread use as a reserve currency has cemented in place an unhealthy and ultimately unsustainable dynamic: The United States has become accustomed to having an ample market for its debt, an expectation that encourages reckless fiscal and economic policies. On this view, this summer's fight over raising the debt ceiling was just a preview of a reckoning to come. As Zhou argued in his 2009 speech, Triffin's dilemma hasn't disappeared after all: The United States cannot supply the world with its reserve currency indefinitely while retaining investors' confidence.

But there's no reason that a more balanced global reserve system requires a super-sovereign currency like the SDR. In theory, other currencies could share the burden (or privilege) of providing the world with a reserve currency. There have been some moves in this direction. The euro has made inroads, though as Harvard University economist Robert Cooper has noted, it has significant limitations. Perhaps the most important one is that there are (for the moment, at least) no debt instruments issued directly by European institutions; a central bank that wants to hold euros must hold national debt denominated in euros. As Barry Eichengreen argued recently, the euro's troubles in any case make it an unattractive alternative to the dollar:

Once upon a time (less than a year ago), it was possible to imagine international-reserve portfolios dominated by the dollar and euro; today, anxious central bankers are desperate for alternatives to both sick currencies.

The problem is that they have nowhere to turn. The gold market is small and volatile. Chinese bonds remain unavailable. Second-tier currencies, like the Swiss franc, the Canadian dollar, and the Australian dollar, are only a slightly larger midget when combined.

Given this bleak landscape, the moment might appear ripe for SDRs to fulfill their original mission. But moving the SDR back to the prominent place it was designed to occupy would be a formidable political and logistical task. At the moment, SDRs can only be held by the IMF, sovereign governments, and a few other official actors (such as the World Bank and the Bank for International Settlements). Private actors cannot hold or trade SDRs, which greatly limits their utility as a reserve currency. For example, governments cannot easily use SDRs to intervene directly in the markets.

There are also far too few SDRs in existence for the unit to make an impression as a reserve currency. "Expanding the volume of official SDRs is a prerequisite for them to play a more meaningful role," acknowledged a recent IMF report. For the SDR to become globally relevant, the IMF's major shareholders would have to make a concerted decision to regularly issue more, create a better mechanism for exchanging SDRs for other widely traded currencies, and alter the rules about who may hold them.

Even its most enthusiastic backers realize that the SDR will have to enter the ring slowly, gradually displacing the dollar. After Zhou's headline-grabbing speech, Chinese leaders have decreased the volume and appear content to move slowly on intermediate reforms like including the renminbi in the basket of currencies that determines the SDR's current value. A more prominent SDR still appears distant. The world may be in the midst of a financial crisis, but there is no consensus that the IMF's neglected global currency is part of the solution.

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Deep Dive

The Multilateral Vacuum

If Washington can't get the Chinese to revalue their currency, can international institutions be of any help?

If there is one thing the world seems to have in abundant supply, it is institutions to coordinate the global economy. This is, in part, because old ones never die; they just set their meetings to occur on the sidelines of the shiny new institutions' gatherings. Somewhere in the alphabet soup of institutional acronyms -- WTO, G-7, G-20, IMF -- it would seem there might be one that could prompt China to revalue its currency. Certainly, Washington's had little luck on its own.  

The challenge is a stiff one. But international economic coordination can sometimes work nicely in resolving such issues. It can help countries escape from an economic prisoner's dilemma -- with each withdrawing tariffs, for example, for mutual gain. The institutions can allow countries to share experiences about which policies have worked and which have fallen short. Or the gatherings of leaders can imbue participants with a sense of accountability for the global repercussions of their domestic actions.

China's undervalued currency fits awkwardly into the prisoner's dilemma framework. There is a strong case to be made that China has been the chief victim of its renminbi policy. It is left with trillions of dollars' worth of foreign exchange reserves on which it looks increasingly likely to take significant losses. The domestic economic adjustment challenges that looked too daunting for China to tackle a few years ago appear even more daunting now. Adding to the concerns, the undervalued renminbi has contributed to a lack of monetary control that has sparked inflation within China.

All these reasons should drive unilateral action on China's part. But any such action has been slowed by domestic political concerns within China. Could an international bargain help overcome those? It's possible. The setting bears some resemblance to trade liberalization, in which countries may be able to forswear counterproductive policies -- such as voluntary export restraints -- while proclaiming political victory because others joined the bargain: "Yes, we have agreed to stop shooting ourselves in the foot, but everyone else will be forced to stop as well!"

This sort of deal was on offer from U.S. Treasury Secretary Timothy Geithner in G-20 talks a year ago. Countries holding major trade surpluses and deficits would have agreed to get their houses in order. China would have had to make politically painful adjustments, but could have claimed that it had won promises of U.S. fiscal rectitude as part of the bargain. In the end, neither China nor Germany seemed to find this offer of foreign pressure politically useful, and the effort got bogged down in a tedious set of negotiations aimed at defining the problem.

There was a time when it seemed plausible that international sharing of economic knowledge and experience could help sway Chinese currency policy. That now seems like another casualty of the global financial crisis, an episode that Chinese leaders seem to believe they won and the West lost. Whether or not the financial crisis renders subsequent Western analysis suspect, Chinese hubris means the advice is unlikely to meet a receptive audience.

But maybe China, as an emerging power, feels obliged to do its share to set the global system aright? This was the thrust of the "responsible stakeholder" policy espoused by World Bank President Robert Zoellick when he served as U.S. deputy secretary of state. No sign of this yet. China remains reluctant to take on either the rights or responsibilities that go with such a leading role. Incongruously, China's leaders seem to want to treat the country's large external imbalances as a purely domestic problem and just be left alone.

Beijing can only dig its head in the sand for so long. Powerful economic forces will compel China to take a different approach to renminbi valuation sooner or later. A prudent policy for the United States might be to wait it out and focus its diplomatic energies on more fruitful directions, such as addressing China's objectionable policies on intellectual property and investment. But patience and prudence can be in short supply amid a sour economy and fractious politics. If there is a political imperative to apply international pressure to accelerate appreciation of the renminbi, what do the different institutional vehicles have to offer?

The International Monetary Fund (IMF) has the most obvious jurisdiction. It was created to help resolve problems with currencies and imbalances. IMF chiefs have spoken publicly of renminbi undervaluation. But there are two big obstacles to moving beyond pure talk. First, the IMF leadership acts only with the consent of its governing board. Recent restructuring moves have aimed to augment China's power on that board, in recognition of its growing economic stature, which obviously puts constraints on how confrontational the organization is likely to be. Second, the IMF's leverage comes primarily through threatening to withhold loans from wayward countries. China is making loans, not seeking them. The IMF can do little more than scold.

What about the World Trade Organization (WTO), which has jurisdiction over trade concerns? Indeed, critics of Chinese exchange rate policies mostly care because of the distortions a cheap renminbi causes in trade flows. And language in the WTO agreements warns against using exchange rate policies to negate promises of trade openness. Further, the WTO has one of the more effective dispute resolution schemes on the global scene. So why not press a case? It only looks like the right place. The organization has little competency on currency matters, and the language in the agreements is exceedingly vague. If presented with a case, the WTO would be faced with an unappealing choice: It could side with China and appear ineffectual, or it could side with the United States and make up critical new rules in a thoroughly arbitrary fashion.

Are bilateral discussions with China the way to go? The latest high-level incarnation of this three-decade-long conversation is the U.S.-China Strategic and Economic Dialogue. It would hardly be a novelty to raise exchange rate concerns in this context; they have been a prime topic of discussion since well back in President George W. Bush's administration. Although China did adopt a gradual currency appreciation policy in 2005 and then again in 2010, there is little evidence that U.S. bilateral pressure played a decisive role. When the issue is raised in a bilateral context, a couple of difficulties arise. First, Chinese leaders are inclined to interpret U.S. concerns as misdirected reflections of U.S. domestic political pressures, rather than legitimate efforts to rebalance the global economy for the greater good. Second, bilateral talks raise the specter of great-power competition. It's no surprise that Beijing may wonder whether Washington is really looking for mutual benefit or whether it is trying to suppress a budding rival.

Could the G-20 then be the Goldilocks institution? It would seem custom-designed to address this issue. Barack Obama's administration lauded the forum for a membership that reflected new global economic realities. Most notably, it brought China to the table whereas its predecessors, the G-7 and G-8, did not. And global rebalancing featured prominently in the G-20's post-crisis agenda. This worked well, so long as the pledges were sufficiently vague. But as soon as the United States moved to translate the vague pledges into obligations and actions, it encountered stiff resistance. In the end, the only real leverage the G-20 offers is the possibility that a single country holding out from an international consensus might be isolated and shamed. China was saved from such a fate when Germany joined in objecting to disciplines on surplus countries.

The short answer is that none of above is the perfect setting to resolve or mitigate this complicated dispute. And the United States shouldn't try to fit a square peg in a round hole. The danger with pressing action through one of these institutions, despite the frailties described above, is that the effort could end up damaging a body that might still be very useful for other, less demanding tasks. One could argue that has already occurred with the G-20, given the weak results from efforts at global rebalancing] To twist a quote from Abraham Lincoln, it is better to leave well enough alone as an international economic institution and have everyone suspect you of impotence than to take on China and remove all doubt. We may be awash in acronymic organizations, but right now, none are well-situated to take on the renminbi.

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