To alleviate the global recession, the G-20 group ofnations recently agreed to authorize the InternationalMonetary Fund to allocate $250 billion worth of

Special Drawing Rights—the IMF’s unit of account—to itsmember states. This sparked much discussion on whether theSDR could become a new international currency, rivaling theU.S. dollar. Speculation was further fueled by the suggestionsof Chinese officials that SDRs could displace the dollar in for-eign exchange reserves. However, the SDR is not a currencyand has no chance of becoming one.

Today the SDR has two roles: as a unit of account, andas a line of credit between IMF members. Neither rolemakes it a currency. The SDR’s value is defined as equal tothat of a basket of four currencies: the U.S. dollar, the euro,the yen, and the pound sterling. Member-states occasion-ally agree to issue SDRs to themselves, and these serve as

mutual lines of credit, providing needy countries access tohard currency. SDR allocations represent purchasing pow-er through a credit facility, not through creation of a newcurrency.

Chinese officials and some leading economists want agreater role for SDRs in foreign exchange reserves. Thiswould shift currency risk away from China to the IMF. Butother IMF members would have to pick up that risk, andthere is no reason for them to subsidize China. Underlyingthe SDR issue is a global struggle for political power. ButChina has a large and growing GDP and tax capacity, whichmay overtake that of the United States one day. Before then,the Chinese yuan will probably become convertible, andbecome a highly sought-after reserve currency in its ownright. The real currency challenge to the dollar will comefrom the yuan, not the SDR.

the cato institute1000 Massachusetts Avenue, N.W., Washington, D.C. 20001-5403

www.cato.orgPhone (202) 842-0200 Fax (202) 842-3490

J u l y 7 , 2 0 0 9 ● n o . 1 0

An International Monetary Fund Currencyto Rival the Dollar?

Why Special Drawing Rights Can’t Play That Role

by Swaminathan S. Anklesaria Aiyar

Swaminathan Aiyar is a research fellow at the Cato Institute’s Center for Global Liberty and Prosperity and has been editor of India’s two biggest financialdailies, The Economic Times and Financial Express.

Executive Summary

Introduction

To help alleviate the global recession, at itsmeeting in Great Britain in April 2009, the G-20 decided, as part of an overall stimulus planof $1 trillion, on a fresh allocation of $250 bil-lion worth of Special Drawing Rights by theInternational Monetary Fund to its memberstates. This immediately raised public interestin the question of whether the SDR will evolveinto a new international currency that supple-ments, and eventually rivals, the dollar. Manypoliticians and economists want an enhancedrole for SDRs in foreign exchange reserves.However, the SDR is not a currency, and neverwill be. It may play other roles, but not that ofa currency.

Currently, the SDR plays two roles. First, it isa unit of account. Its value is defined as the val-ue of a weighted basket of four currencies. TheSDR basket has weights of 44 percent for theU.S. dollar, 34 percent for the euro, and 11 per-cent each for the yen and pound sterling. Thevalue of an SDR at current exchange rates isaround $1.50. Its value fluctuates with the valueof its constituent currencies. This should makeit clear that the SDR is not a currency in its ownright. Rather, it is a derivative of four nationalcurrencies. A derivative is not a currency.

The SDR can be used as a unit of account.Transactions, loans, and contracts are usuallydesignated in a single currency, like the dollar.But they can also be designated in SDRs, sothat the currency risk of the contract is diversi-fied among four currencies. Some SDR-denominated contracts and transactions doindeed take place on a limited scale. The IMF iscurrently planning to issue bonds worth up to$500 billion that will be denominated in SDRs.This would increase the global reserves denom-inated in SDRs until the bonds mature a yearlater. But the bond issuance will not make theSDR a separate international currency; it willsimply mean the SDR is being used more wide-ly as a unit of account for bonds and othertransactions.

The second role of the SDR is as a mutualline of credit for members of the IMF. The

IMF has so far allocated a total of 21.3 billionSDRs to its members in proportion to theirshareholding. If a needy country like Turkeyhas a balance of payments deficit, it can askthe IMF to convert, say, 100 million SDRs ofits allocation into dollars (or yen or any othercurrency). The IMF will debit Turkey’s SDRaccount by 100 million, and credit the SDRaccount of the United States by the same sum.In return, the United States will hand over thedollar equivalent of 100 million SDRs to theIMF, which will hand that over to Turkey. So,the IMF acts as a middleman for credit linesfrom SDR-surplus to SDR-deficit countries.The credit and debit balances carry interest, atrates linked to rich-country bonds. Debtorcountries would normally pay much higherrates, so the SDR line of credit can be viewedfrom the borrower’s viewpoint as being subsi-dized, although it is not explicitly subsidizedby the lender. SDR allocations add to the pur-chasing power of needy IMF members, whoview it as especially valuable since it is not sub-ject to the conditionalities of normal IMFloans. But clearly this limited role of the SDR,providing modest quantities of unconditionalfinancial assistance, does not make it a newcurrency.

However, many countries and economistsfeel that the existing system of internationalreserves has deep flaws, and that remediesmight include a substantially expanded rolefor the IMF and SDRs. To understand thesenew reforms, a brief history of the evolution ofreserve currencies and of the SDR is helpful.

Historical Background:The Evolution of

Reserve Currencies1

Before World War I, most countries wereon the gold standard: their currency issue wastied to the gold held in their reserves. A coun-try whose gold holdings fell had to shrink itsmoney supply too. Such stiff discipline meantthat inflation was close to zero—a clear bene-fit. But the gold standard deprived countriesof the monetary flexibility to combat adverse

2

Many politiciansand economists

want an enhancedrole for SDRs in

foreign exchangereserves.

conditions: they could not print currency tomeet politically urgent expenses.

Governments wanted to spend enormoussums in World War I and so gave up the goldstandard for the printing press. Besides, thebulk of gold production came from Russiaand South Africa, and others were not happyat the notion that they were at the mercy ofthose two countries for future money supply,or that those two countries should have sucha huge advantage over all others.

Some countries sought to reinstate thegold standard after World War I, but the effortwas short-lived. Use of the printing press bygovernments became standard practice. Thisled to higher inflation, and in a few extremecases to hyperinflation. This led to calls fromsome economists for a more disciplined sys-tem, and maybe even a return to the gold stan-dard. But the political consensus was to givegovernments the power to issue money at will.

This continues to be the case today. Givenrising public demands on governments, andwhat governments themselves feel inclined todo, they have decided—across the globe—thatinflation is a price worth paying for the flexibil-ity that the printing press provides. The samevoters who approve of government activismand spending also complain about inflation.But, on the whole, voters appear to prefer elect-ing relatively activist governments plus infla-tion over more limited governments focusingon stable prices.

The abandonment of the gold standardafter World War I may have given govern-ments flexibility, but certainly did not guaran-tee economic stability or success. The RoaringTwenties were followed by the Great Depres-sion in 1929, which created a decade of miseryuntil it was ended by the demands of wareconomies in World War II. During the GreatDepression, competitive devaluations by dif-ferent countries constituted a form of protec-tionism that invited retaliation by tradingpartners. The net result was a huge shrinkageof world trade, a fall in world GDP, and wide-spread unemployment and distress.

In 1944, major market economies gatheredat Bretton Woods, New Hampshire, to devise a

post-war monetary system. The British econo-mist John Maynard Keynes had written aboutthe possible advantages of creating a newinternational currency—Bancor—which wouldbe anchored in 30 commodities. But there wasno political will to give up national currenciesor the printing press. The U.S. economy was byfar the strongest in the world at the time, andthe U.S. dollar was the strongest currency. Soinstead, the Bretton Woods meeting agreed oncreating the International Monetary Fund tooversee a new international system that wouldbe anchored to the dollar—the only currencyconvertible to gold by central banks. Theexchange rates of other currencies were fixedin relation to the dollar, and any changes inexchange rates were to be negotiated with theIMF in order to prevent the competitive deval-uations that had wrecked the world economyin the 1930s.

Immediately after World War II, muchworld trade was still done by barter or by spe-cial arrangements (for instance, countries withsterling balances could use them to buyBritish goods, but not goods from other coun-tries). The Marshall Plan (1948–1951) soughtto aid the revival of war-hit economies andaimed for the restoration of currency convert-ibility on current account. But it was only in1958 that European economies were able toachieve this aim, and Japan followed in 1964.Convertibility on capital account was not partof the Bretton Woods framework, and camedecades later.

The Bretton Woods system appeared to givethe United States an advantage: it had the onlyconvertible currency, and so could issuedomestic currency to pay its import bills. Theconvertibility was not absolute; individualscould not demand gold for dollars, but foreigncentral banks could. As world trade grew in the1950s and 1960s, and countries accumulatedrising stocks of dollars in their foreignexchange reserves, it became apparent that theUnited States would run out of gold if everyforeign central bank demanded gold for dol-lars. President Charles de Gaulle of Franceaggressively converted his dollars into gold,partly out of resentment of dollar dominance,

3

The SDR is not a currency andnever can be.

and partly out of fear that the United Stateswould ultimately not be able or willing to hon-or its gold convertibility. The U.S. governmentfound this potential attack on its gold reservesuncomfortable, and also found that theBretton Woods system denied it the flexibilityto devalue to improve its trade balance.Eventually President Richard Nixon devaluedthe dollar and ended convertibility to gold in1971.2 An attempt was made to refix exchangerates of the biggest economies (the so-calledSmithsonian Agreement) within a small trad-ing band. But this arrangement soon brokedown and currencies began floating.

Many economists feared that global tradewould be hit by the uncertainty of floating cur-rencies. There were indeed major ups anddowns. The dollar was weak in the 1970s, butappreciated very sharply in the early 1980s.That rise was finally checked by the Plazaaccord of 1985, when major countries usedcoordinated currency intervention to reversethe dollar’s rise. One of the aims of doing sowas to reduce the U.S. trade deficit, which hadsoared to 3.5 percent of GDP because thestrong dollar sucked in imports and madeexports less profitable. The U.S. trade deficitwith Europe did indeed fall, though not itsdeficit with Japan. The 1987 Louvre accordended the decline of the dollar. World tradecontinued to boom in the next two decades,notwithstanding recessions in 1991 and 2001.The experience ended earlier fears that floatingcurrencies would damage trade.

The emergence of floating currencies great-ly eroded the importance of foreign exchangereserves. Earlier, under the old Bretton Woodssystem of fixed exchange rates, a country need-ed foreign exchange reserves to plug currentaccount deficits. Then, in the early days offloating, countries also used foreign exchangereserves to intervene in currency markets andtry to defend implicit or explicit exchangerates. But as time went by, countries becameincreasingly comfortable with currency fluctu-ations and greatly reduced their interventionsin currency markets. Even in floating regimes,central banks sometimes intervened to pre-vent extreme movements—this was called a

managed float. The European MonetaryUnion aimed at harmonizing currencies with-in the EU, and eventually produced the euro.The dollar value in the last ten years fluctuat-ed between $0.80 and $1.60 to the euro, yetthis huge currency fluctuation did not dam-age the world financial or trading system.

However, many developing countrieswanted to have implicitly or explicitly peggedexchange rates. A few countries like HongKong or Saudi Arabia pegged their currenciesto the dollar: they felt too dependent on tradeto try to manage an independent currencyregime. But some other countries aimed forundervalued exchange rates to facilitateexport-oriented growth. The central banks ofsuch countries would, if faced with a majordollar inflow, buy up much of the inflowrather than let their currency appreciate, andthen park those dollar surpluses in their for-eign exchange reserves.

China was the main such country, and itsapproach was widely criticized by economistswho correctly viewed it as mercantilist. Itsought to pile up foreign exchange reservesrather than let its currency appreciate, loweringthe price of imports for its citizens. However,the Chinese government felt that the advan-tages of mercantilism more than offset thecosts. After all, China’s overall policies—includ-ing trade liberalization and deregulation—made it the fastest-growing country in theworld. In the process, it also accumulated thelargest foreign exchange reserves in the world.

During the Asian financial crisis of1997–2000, the United States began runninglarge trade deficits. This was very useful inenabling the stricken Asian economies torecover as they relied on the United States toplay the role of importer of last resort. But thatcrisis left an impression in Asia that theireconomies were highly vulnerable to capitaloutflows. As long as Asian countries chose todeviate from a market-based exchange ratemechanism that was either fully fixed, as in thecase of Hong Kong, or fully floating, theywould need to rely on a discretionary policy ofreserve accumulation to defend their peggedrates. So they resolved to build high foreign

4

Governmentswanted to spendenormous sumsin World War Iand so gave up

the gold standardfor the printing

press.

exchange reserves to ensure future safety. Thismeant running high current account surplus-es, which in turn meant aiming at undervaluedexchange rates plus high domestic savings.China was the champion in both respects.

Asian countries could not run huge currentaccount surpluses unless some others were will-ing to run corresponding deficits. The deficitrole was taken on mainly by the United Statesand the United Kingdom. The trade deficits ofthese countries were financed by a huge transferof hard currency to Asian countries (mainlyChina) and OPEC members. These countriesput the hard currency in foreign exchangereserves—meaning they purchased bonds desig-nated in dollars, euros, yen, and sterling—thefour major hard currencies. Chinese foreignexchange reserves skyrocketed (see Figure 1), asdid Chinese holdings of United States bonds,which are now valued at about $768 billion.3

This huge demand for U.S. bonds depressedlong-term U.S. interest rates and induced a U.S.borrowing spree, both for spending and for

buying assets. The U.S. buying spree created thecurrent account deficit required to match theAsian surpluses. The asset-buying spree led tobubbles in the housing market, the stock mar-ket, and ultimately the commodity market, asfinanciers pounced on commodities as onemore asset class.

This is the interpretation of events favoredby many U.S. analysts, notably Ben Bernanke,chairman of the U.S. Federal Reserve Board.This interpretation views the root cause ofmacroeconomic imbalances as China’s “sav-ings glut.” In fact, the macroeconomic imbal-ances flowed not just from China’s savings glutto the United States, but from the U.S. profli-gacy towards China. The Federal ReserveBoard kept interest rates in the United Statestoo low, especially from 2003 onward, and U.S.lawmakers and regulators encouraged hugeborrowing by financial institutions, corpora-tions, and homeowners.4 Loose money plus fis-cal deficits stemming from the Iraq war suckedin huge imports, creating trade deficits. Thus

5

Economists saw in the SDR a possible resurrection ofKeynes’s idea ofBancor as a newinternational currency.

Figure 1

Chinese Foreign Exchange Reserves (minus gold) ($US billions)

Source: State Administration of Foreign Exchange, People's Republic of China.

Chinese mercantilism and U.S. overspendingfed on one another in a vicious cycle.

Not even the strongest economy in theworld, the United States, could keep on run-ning current account deficits in excess of 5percent of GDP. It was equally unfeasible forChina to keep household consumption atless than half its GDP and use huge excesssavings to build up foreign exchange reserves.These global imbalances were unsustainableand helped create bubbles that were boundto burst at some point. In 2008, global creditcollapsed and financial markets froze in fear.Production and employment plummeted asthe whole world slipped into what some nowcall the Great Recession.5

Governments around the world came outwith stimulus packages, involving fiscal andmonetary expansion. They all decided to runhuge budget deficits to pump purchasing pow-er into their economies. And they expandedmoney supply to rush liquidity into frozenmarkets. Interest rates were slashed—down tothe range 0–0.25% in the case of the UnitedStates. Quantitative easing—the printing ofcurrency by central banks—began on a massivescale. The U.S. Federal Reserve injected a whop-ping $2 trillion into U.S. markets, an unprece-dented avalanche of money. Other countriesacross the globe followed suit.

In pursuit of the same economic logic, theG-20 proposed a fresh IMF allocation of$250 billion worth of SDRs. The aim was notto move toward a new world currency, but toprovide hard currency access to countries suf-fering a sudden disappearance of global liq-uidity. Since 1981, the major shareholders ofthe IMF had failed to agree on the creation offresh SDRs, mainly because of fears that thatthis would be inflationary. But in the contextof the Great Recession, these fears were setaside.

Evolution of the SDR

How did SDRs come about? In the 1950sand 1960s, world trade was rising fast. The dol-lar and gold were the only two reserve curren-

cies at the time. Fears arose that the supply ofreserves might not be enough to grease thewheels of world trade. If the United States ranlarge trade deficits, it would of course flood theworld with more than enough reserve money.But if the United States ran a zero deficit or acurrent account surplus, this could lead to ashortage of reserve currency and a slowdown oftrade. Hence, a demand arose for creating addi-tional reserve money, possibly through theIMF. This was the genesis of the SDR.

Many economists saw in the SDR a possibleresurrection of Keynes’s idea of Bancor as anew international currency. But no countrywanted to give the IMF the right to print mon-ey on its account. So, the SDR was devised asneither a currency nor a claim on the IMF. Inofficial jargon, it was described as a potentialclaim by all IMF members on the hard curren-cy issued by a handful of strong countries.6 Insimple language, SDRs were lines of creditextended by IMF members to one another. Intheory, the United States could use its SDRallocation to purchase the currency of Liberiaor Togo, but of course there was no interest atall in such transactions. The key feature of theSDR arrangement was that Liberia or Togocould exchange their SDR allocations for dol-lars, or other hard currency. The hard-currencycountries were obliged to accept SDRs fromweak members. Naturally, the hard-currencymembers were conservative about giving suchunconditional lines of credit. That explainswhy SDR allocations were few and far between.

The value of the SDR was initially defined asequivalent to 0.888671 grams of fine gold—which, at the time, was also equivalent to oneU.S. dollar. After the collapse of the BrettonWoods system in 1973, however, the SDR wasredefined as a basket of currencies. The baskettoday consists of the U.S. dollar, euro, Japaneseyen, and British pound sterling, in the ratio of44:34:11:11. The basket composition is review-ed every five years to ensure that it reflects therelative importance of currencies in the world’strading and financial systems. The SDR interestrate is determined weekly as a weighted averageof interest rates on three-month bonds of thecurrencies in the SDR basket.

6

With the breakdown of the

Bretton Woodssystem in the

early 1970s,reserves were no

longer needed ona global scale to

maintain fixedexchange rates.

The amendment of the articles of the IMFwhich provided for the issue of SDRs made itclear that the IMF could not allocate SDRs toitself. If it could, it might indeed have becomea creator of new money, but it has been pro-hibited from doing so. Its role is simply tomanage the mutual lines of credit that con-stitute SDR allocations.

There are two kinds of SDR allocations.General allocations of SDRs are based on a per-ceived long-term global need to supplementexisting reserve assets. The first such allocationwas for SDR 9.3 billion, distributed in 1970–72.The second allocation of 12.1 billion SDRs wasdistributed in 1979–81 and brought the cumu-lative total of SDR allocations to SDR 21.4 bil-lion.

After that, no SDR allocations were madeuntil the latest G-20 decision. Why were noSDRs created for decades? First, with thebreakdown of the Bretton Woods system inthe early 1970s and the floating of currencies,reserves were no longer needed on a globalscale to enable countries to maintain fixedexchange rates. That initial justification forfresh SDR allocations therefore faded away.Secondly, fears arose that additional SDRissues would stoke inflation. From the 1980sonwards, many central banks adopted a poli-cy of targeting low rates of inflation, and ofnot printing money to monetize governmentdeficits. This inflation focus did not sit wellwith the idea of issuing new SDRs that wouldexpand global purchasing power and tend tocreate inflation.

In 1997, the IMF considered a proposal fora special one-time allocation of SDRs throughthe Fourth Amendment of the Articles ofAgreement. This allocation would have dou-bled outstanding SDR allocations to SDR 42.8billion. Its intent was to enable all members ofthe IMF to participate in the SDR system on abasis more accurately reflecting the relative sizeof members’ economies, and correct for thefact that many countries that joined the IMFafter 1981—more than one-fifth of its mem-bership—had never received an SDR allocation.The Fourth Amendment was to become effec-tive when three-fifths of the IMF membership

(111 members), with 85 percent of the totalvoting power, accepted it. Currently, 131 mem-bers, with 77.68 percent of total voting power,have accepted the proposed amendment. Butthe United States, with 16.75 percent of thetotal votes, refused to accept the amendment,which therefore did not cross the approvalthreshold.

The Great Recession finally persuaded theUnited States to relent and agree to a freshissue of SDR 250 billion. When fear grippedcredit markets after the collapse of LehmanBrothers in September 2008, normal tradecredit to many developing countries sudden-ly dried up. Countries found it difficult toopen the usual letters of credit that had fordecades routinely provided short-term creditfor their imports. The meltdown’s impact ontheir capital account was in some cases evengreater. Emerging markets had earlier bene-fited from capital inflows of around $600 bil-lion in 2007, but after the meltdown, theycould face an outflow of up to $180 billion in2009.7

Developing countries could and did injectdomestic currencies into their own marketsto stimulate domestic economic activity. Butonly an external injection could providesome international liquidity to compensatefor the fear-induced disappearance of capitalflows and trade credit. Fresh liquidity couldhelp not only developing countries but devel-oped ones too: the additional liquidity wouldenable developing countries to import morefrom developed ones. A consensus amongworld leaders emerged that additional liquid-ity was needed to grease international trade.This facilitated the G-20 decision on a freshallocation of $250 billion worth of SDRs, aspart of a total stimulus package of $1 trillion.Of this $250 billion, barely $100 billion willaccrue to developing countries, and some bigallottees among developing countries (suchas China and Saudi Arabia) have no shortageof foreign exchange. Maybe $50–80 billion ofthe additional allocation will be used bycountries in need. That is a significant sumfor distressed economies, but very modest interms of adding to globally usable reserves.

7

China fears thatthe dollar—andChina’s reserves—will crash.

The new SDR issue represents quantitativeeasing at the international level to supplementquantitative easing within countries like theUnited States. This has potentially inflationaryrisks. In the middle of a recession, quantitativeeasing will tend to stoke sales rather thanprices. Yet when normalcy returns, the hugeoverhang of money will become inflationary,and the U.S. Fed will have to find some way ofsucking the money out of the system withoutcausing another recession. This will be politi-cally and financially tricky. When inflationaryfears return—as they surely will once the GreatRecession ends—key IMF members will onceagain become very reluctant to agree to furtherSDR allocations. As happened after 1981, anti-inflation sentiment might thwart further SDRallocations for decades.

However, for reasons totally unrelated toliquidity, some other developing countriesseek a much-expanded role for the SDR.China and some other countries want toexplore ways to upgrade the SDR into a super-sovereign reserve asset. These countries holdtrillions of dollars in their foreign exchangereserves. With the United States printing tril-lions of dollars to stimulate the U.S. economy,China fears that the dollar—and China’s ownreserves—will crash, a fear shared by many U.S.economists, too. Hence, China wants SDRs asa rival reserve currency. Other countries, aswell as some eminent economists, have backedthis proposal.

Replacing the Dollar withthe SDR as a Reserve Asset

In the 1970s, as is the case today, therewere fears that inflation would erode thefuture value of the dollar, and hence of for-eign exchange reserves held in dollars. Notsurprisingly, the proposed solutions at thattime resemble the ones being proposed byChina today. In the 1970s, IMF staff workedout details of a scheme called the IMF substi-tution account.8 Countries would be able todeposit dollar securities into this account,and in return the IMF would give them secu-

rities designated in SDRs. Since the SDR wasa basket of currencies, SDR-designated secu-rities would be more stable in value than dol-lar securities, and countries with SDR-desig-nated reserves would have less currency riskthan those holding dollar securities alone.The obvious objection to the substitutionaccount was that it would, in effect, transferthe currency risk from surplus-dollar coun-tries to other members of the IMF. Mainly forthis reason, the scheme never got off theground.

However, this approach been resurrected bythe governor of the People’s Bank of China,Zhou Xiaochuan, in recent speeches and writ-ings. Consider the following passages fromZhou’s widely noted speech on March 23, 2009:

The outbreak of the current crisis and itsspillover in the world have confronted uswith a long-existing but still unansweredquestion: what kind of internationalreserve currency do we need to secureglobal financial stability and facilitateworld economic growth, which was oneof the purposes for establishing the IMF?. . . Issuing countries of reserve currenciesare constantly confronted with the di-lemma between achieving their domesticmonetary policy goals and meeting othercountries’ demand for reserve currencies.On the one hand, the monetary authori-ties cannot simply focus on domesticgoals without carrying out their interna-tional responsibilities. On the otherhand, they cannot pursue differentdomestic and international objectives atthe same time. They may either fail toadequately meet the demand of a grow-ing global economy for liquidity as theytry to ease inflation pressures at home, orcreate excess liquidity in the global mar-kets by overly stimulating domesticdemand. . . .

The desirable goal of reforming theinternational monetary system, therefore,is to create an international reserve cur-rency that is disconnected from individ-ual nations and is able to remain stable in

8

China can diversify its

reserves gradually,

without causinghuge currency

gyrations.

the long run, thus removing the inherentdeficiencies caused by using credit-basednational currencies. . . . Compared withseparate management of reserves by indi-vidual countries, the centralized manage-ment of part of the global reserve by atrustworthy international institutionwith a reasonable return to encourageparticipation will be more effective indeterring speculation and stabilizingfinancial markets. The participatingcountries can also save some reserve fordomestic development and economicgrowth. With its universal membership,its unique mandate of maintaining mon-etary and financial stability, and as aninternational “supervisor” on the macro-economic policies of its member coun-tries, the IMF, equipped with its expertise,is endowed with a natural advantage toact as the manager of its member coun-tries’ reserves. . . . The centralized manage-ment of its member countries’ reserves bythe Fund will be an effective measure topromote a greater role of the SDR as areserve currency. To achieve this, the IMF canset up an open-ended SDR-denominated fundbased on the market practice, allowing subscrip-tion and redemption in the existing reserve cur-rencies by various investors as desired [empha-sis added]. This arrangement will not onlypromote the development of SDR-denominated assets, but will also partial-ly allow management of the liquidity inthe form of the existing reserve currencies.It can even lay a foundation for increasingSDR allocation to gradually replace exist-ing reserve currencies with the SDR.9

Zhou’s proposed solution—an open-endedSDR denominated fund—looks similar to thesubstitution account first proposed in the1970s. It has been supported strongly by someeconomists, notably Fred Bergsten of thePeterson Institute of International Economics.According to Bergsten, “The risk is that Chinaand perhaps other monetary authorities,together holding more than 5 trillion in dollarreserves, will lose confidence in the dollar

owing to the prospects for huge and sustainedbudget deficits in the U.S.” If China dumpsdollars to buy euros, this would send the dollarinto free fall and send the euro skyrocketing.Far better, argues Bergsten, would be a substi-tution account that he claims would be a win-win proposition for all concerned. “The dollarholders would obtain instant diversification.The U.S. would avoid the risk of a free fall ofthe dollar. Europe would prevent a sharp rise inthe euro. The global system would eliminate apotential source of great instability.”10

However, there are two obvious objectionsto the scheme. First, China has accumulatedits dollar hoard through mercantilist policiesthat have been criticized widely. Chinaappears to have gained tremendously in GDPthrough such mercantilism, but it has comeat a high cost, including the cost of piling upcurrency risk in its foreign exchange re-serves.11 If China suffers because of a fall inthe dollar, it surely deserves to suffer the con-sequences of its own mercantilism. Why res-cue a mercantilist?12 Let China diversify intoeuros or yen at its own pace. In any case, thereis no reason to think it will dump dollars onsuch a huge scale as to send the dollar plum-meting—that would be shooting itself in thefoot. China can diversify its reserves gradual-ly, without causing huge currency gyrations,and with the same outcome as a substitutionaccount. Suppose, for instance, that Chinawants to use the substitution account toexchange $100 billion into SDR securities. Ifso, the break-up value of those SDR securitieswill be $44 billion worth of dollars, $34 bil-lion worth of euros, and $11 billion wortheach of yen and sterling. But China could justas well convert $100 billion of its existingreserves into the same mix of four currenciesthrough market transactions. No IMF helpor subsidy is needed.

Indeed, China can rearrange its entirereserves with weights of 44 percent for the dol-lar, 34 percent for the euro, and 11 percenteach for the yen and pound sterling. This willhave exactly the same effect as converting itsentire foreign exchange reserves into SDRs!This drives home the point that the SDR is

9

The SDR is best viewed as a currencyexchange tradedfund.

best viewed as a currency exchange tradedfund. ETFs are bundles of assets tracking awell-known index, such as the 30 companiesin the Dow Jones Industrial Index. The SDR isa currency ETF that tracks four currencies.ETFs represent no more than a convenientbundle of existing assets, and do not consti-tute a new asset. Any portfolio can contain thecomponents of an ETF rather than the ETFitself, and the outcome will be the same.

Bergsten has argued that if Chinese-helddollars are not switched into SDRs, thenChina may dump huge quantities of dollarson the market if it feels severely threatened byU.S. protectionism, or if there is a flare-up overTaiwan or the Dalai Lama.13 However, the sub-stitution account will not change this risk. IfChina wants to penalize the United States, itcan simply dump SDRs for euros, and this willhit the dollar, which constitutes 44 percent ofthe SDR basket. The political power to penal-ize does not depend on the composition ofone’s reserves.

The second objection to a substitutionaccount is that it will transfer a big currencyrisk from China to the IMF. Bergsten believesthat the risk is limited, and that if necessarythe gold holdings of the IMF can be used togive extra comfort to holders of the SDR secu-rities. But members of the IMF want the goldto be used for other purposes, notably forincreasing lines of credit or providing cheaperloans to poor countries. Why use the gold tosubsidize the portfolio diversification of dol-lar-surplus countries like China and SaudiArabia? This cannot be a priority for the over-whelming majority of countries, rich or poor.

In fact the risks of the substitution accountare not small; they are very substantial. Anopen-ended substitution account of the sortZhou mentions could end up receiving tril-lions of dollar securities, and issuing trillionsof SDR securities in exchange. If the dollarfalls, the assets of the IMF (the dollar securitiesit has acquired) will be worth much less thanits liabilities (the SDR securities it has issued).The resulting hole in its accounts could behundreds of billions of dollars. Who will plugthe resulting hole? The United States and oth-

er major shareholders have no interest indoing so, but they will be called to do so. Alarge hole will reduce and possibly destroyaltogether the IMF’s ability to lend to its poor-est members, many of whom ironically see thesubstitution account as a quasi-political wayof reducing the dollar’s dominance.

The risks of the substitution account canbe understood by looking at the parallels withthe housing meltdown in the United States.One cause of the meltdown was the emergenceof Collateralized Debt Obligations. Cleverfinancial engineers combined bits of subprimemortgages with prime mortgages, and arguedpersuasively that the package would be virtu-ally risk-free. Rating agencies like Moody’sgave the CDOs a rating of AAA. We now knowthis was a huge boondoggle. After the melt-down, we are on guard against schemes tolaunder BBB mortgages into AAA securities.

The substitution account is, in essence, acomparable laundering scheme. Dollar secu-rities are proposed to be laundered into SDRsecurities, accompanied by assurances fromfinancial experts that the risk is really quitemanageable. The proposed SDR securitieswill be CDOs of the IMF: that is, these secu-rities will be debt obligations of the IMF,backed by dollar securities as collateral. Themajor shareholders of the IMF are aware ofthe risk, and for that reason, the substitutionaccount right now is not under active discus-sion in the IMF.

However, many economists feel that thecurrent reserve system is so flawed that majorreforms are indeed required.14 The macroeco-nomic imbalances leading to the GreatRecession arose, in part, from the determina-tion of Asian countries to build huge foreignexchange reserves, and to avoid any future rep-etition of the Asian financial crisis. The currentmeltdown appears to have vindicated thisapproach, and will strengthen the Asian resolveto keep high reserves. This approach can becalled reserve anxiety. Economist Martin Wolfwrites:

While the international monetary systemis indeed defective, this is hardly the sole

10

The proposedSDR securities

will beCollaterilized

Debt Obligationsof the IMF.

reason for the world’s vast accumulationof foreign reserves. Another is overre-liance on export-led growth. Neverthe-less, Governor Zhou is correct that partof the long-term solution of the crisis is asystem of reserve creation that allowsemerging economies to run currentaccount deficits safely.15

High foreign exchange reserves imply that acountry is saving more than it needs for invest-ment, and stashing the excess into foreignsecurities. An excess of savings in China andother surplus countries contributed to today’smeltdown. To rectify global imbalances, theUnited States and the United Kingdom need tosave much more, and Asia needs to save muchless. The U.S. household savings rate, whichhad fallen to zero, is now up to 5 percent or so.This needs to be matched by smaller savings inAsia. But if Asians seek to keep their reserveshigh, they will in effect be saving too much.And if both the United States and Asia aim forhigh savings, and neither encourage spending,then the Great Recession could become anoth-er Great Depression.

Hence, some economists seek a reform ofthe foreign exchange reserve system to assuagereserve anxiety and prevent another build-upof macroeconomic imbalances. Asian and oth-er developing countries want assurances thatthey will survive future shocks without verylarge reserves. These other proposals haveincluded the tripling of IMF quotas (thoughmost IMF loans carry politically tricky condi-tionalities) and access to the newly createdIMF flexible credit line that enables pre-quali-fied countries to get unconditional access toIMF funds. Mexico, Poland, and others havesigned up for this credit line, which they hopethey will never have to use. They believe thatthe mere existence of the credit line will thwartconcern on the part of other creditors.

The United States Federal Reserve has uni-laterally provided swap facilities of $30 billionto Brazil, Mexico, Singapore, and South Korea,to reduce reserve anxiety and ensure liquidityto its trading partners. China has offered swaplines to select developing countries. Large, fresh

SDR allocations would amount to a multilat-eral swap facility between members. All thesemeasures might relieve reserve anxiety.

Independent of their merit or lack of mer-it, however, all these are technocratic solu-tions to the reserve problem. In the publicdebate, the more important issue is political.

The Politics of a New Currency

Technocrats know well that the SDR isnot a currency and cannot become one. Yetthe media and pubic debates remain full ofspeculation about a new international cur-rency, drawing on concerns around the worldof U.S. dominance and the possibility that itcan be trimmed by ushering in a new curren-cy that will diminish the stature of the dollar.

Now, the IMF does not have too manyadmirers across the world. It has been attackedby many developing countries—among otherreasons, for serving the interests of the UnitedStates and Europe, which dominate the share-holding and decisionmaking of the IMF. Yetthe shareholding of China and other develop-ing countries in the IMF is likely to rise, andthat of the United States and Europe to fall, incoming years. So, despite their reservationsabout the IMF, many developing countrieswould nevertheless like power to shift fromthe United States and Europe to the IMF, thusreducing U.S. political and financial clout.Developing countries believe they would havesome say over an IMF-managed currency,which they view as better than having no say atall over U.S. currency. However, for its owneconomic and political reasons, the UnitedStates has no interest in trying to engineer ashift of power from itself to the IMF, or fromthe U.S. dollar to the SDR.

Indeed, U.S. resistance to more frequentSDR allocations stems not just from worriesabout inflation, but from the political conse-quences, too. The main effect of SDR alloca-tions is to provide additional purchasing pow-er for poorer countries. To this extent, theallocations resemble aid. But this aid goes not

11

Lending money isnot an excercisein democracy.

just to governments the United States wouldlike to help, but to others whom it believesmight not merit it, and still others it mightwant to sanction rather than help—for exam-ple, Venezuela, Iran, Zimbabwe, Myanmar,Syria, and Sudan. Washington would rathergive bilateral aid to its friends than SDR allo-cations to all countries—which includes itsfoes.

Bennett McCallum of Carnegie Mellon Uni-versity made the following remarks in Washing-ton about China’s desire to replace dollars withSDR credits in the IMF:

It is not foolish for China to have sucha desire. But it would be foolish for theU.S. to support a reorganization of theinternational monetary system thatturns over control to the IMF, especial-ly as the political structure of thatorganization will likely be changingover time in ways that will reduce theinfluence of the U.S. over its decisionsand actions. Such support would also,arguably, be foolish from the stand-point of the world as a whole. In thisregard, one needs to imagine how theworld’s international monetary systemwould function if it were managed byan agency of the United Nations.16

Although it is self-evident to McCallum thatthe UN was a politicized bumbler, in develop-ing countries speeches are routinely madeexhorting IMF reforms that will make theorganization more democratic, like the UN. Atthe spring meeting of the IMF in April 2009,Brazilian Finance Minister Guido Mantegacomplained of a “democratic deficit” in theIMF.17 Borrowers might like a greater say inthe IMF, but lenders understandably will (andshould) resist a system in which borrowershave as much say as lenders. Lending money isnot an exercise in democracy.

Rather, voting at the IMF reflects the share-holding of its members. The shareholding ofcountries in the IMF is modified every fiveyears, taking into account changes in the eco-nomic profile and trading importance of dif-

ferent countries. At present the U.S. vote sharein the IMF is 16.77 percent, followed by Japanwith 6.02 percent. China comes well down thelist (3.66 percent), and further down are SaudiArabia (3.16 percent), Russia (2.69 percent),India (1.89 percent), Brazil (1.38 percent), andSouth Korea (1.33 percent). Third Worldcountries have a voting share that is far lessthan their share in world GDP. They look for-ward to the day when they will have a majorityof shares, believing that will change the bal-ance of power in decisionmaking. The IMFrequires a majority of 85 percent for key deci-sions like amending Articles of Agreement orapproving gold sales. The United States, withits 16.77 percent share, has an effective vetotoday over such decisions. If the United Statesshare falls below the 15-percent threshold inthe future, that will end the U.S. veto.

The next quota review of the IMF is due in2013, but may be brought forward to 2011.China hopes that its voting share will increaseto 6.3 percent, making its share second only tothat of the United States.18 That will give Chinaa greater say in the world economy. ThirdWorld countries see in this the hope of reducedU.S. dominance. Yet that hope may miss alto-gether the great new partnership that some seeas arising between the United States andChina. Historian Niall Ferguson has spoken ofa new United States-China condominium,which he calls Chimerica. He believes this newcombination will dominate the 21st century,replacing older 20th-century power structures.Martin Wolf has written about the UnitedStates and China as representing a new G-2(Group of Two) that will replace larger groupslike the G-8 or G-20 in decisionmaking. If thishappens, China will clearly have abandonedthe Third World for a new partnership with theUnited States. The consequences for otherdeveloping countries are not clear.

But one thing seems clear. The really bigchange on the horizon as regards internation-al reserves is the arrival of the Chinese yuan asa fully convertible currency that floats and isnot actively managed by the People’s Bank ofChina. This may take more than a decade tooccur. But when it happens, the Chinese yuan

12

The really bigchange on thehorizon is thearrival of the

Chinese yuan as afully convertible

currency.

itself will become an important and sought-after reserve currency. As a floater, China itselfwill no longer require large reserves, and so itsinterest in the substitution account and othertechnocratic remedies will diminish greatly.The problem of the dollar overhang in reserveswill largely disappear. As an issuer of reservecurrency, China will finally get the politicalstature and clout that it has long sought.

The dollar and euro are strong currenciestoday not because of some political manipula-tion within international organizations, butbecause the United States and Europe are eco-nomic powerhouses. Their currencies haveearned their strength and credibility throughperformance—the market believes that theywill always be freely convertible. The dollar is ahard currency because the United States has ahuge GDP and the capacity to tax its citizensto satisfy all currency commitments. The IMFhas no GDP and no taxing capacity, and solacks the fundamental requirements for creat-ing a currency. U.S. and European politiciansmay occasionally agree to an expanded role forSDRs, but will never surrender money-creat-ing power to the IMF.

However, China has a large and fast-grow-ing GDP and tax capacity. The size of China’seconomy will grow larger than that of theUnited States one day. Well before then, theChinese yuan will probably become an impor-tant reserve asset. The future rival to the dollaris thus the yuan, not the SDR.

China itself seems not to have grasped this.Historically, countries move from having softcurrencies to hard currencies only after run-ning current account surpluses for a signifi-cant period, and hence emerging as creditorcountries. The United Kingdom achievedcreditor status in the 1800s and the UnitedStates in the early 1900s, and the markets re-warded them with hard-currency status. Oncea country establishes credibility in the mar-kets, it continues to have hard-currency statuseven if it runs deficits.

China has now achieved creditor status. Soit can, and surely will, aim for hard-currencystatus in a decade or so. Ironically, it may haveproved that the emergence of a large new hard-

currency superpower causes macroeconomicimbalances. Once it becomes a hard currencycountry, China will find no advantages—andsee clear disadvantages—in an IMF substitu-tion account, just as the United States doestoday. But as of now, China retains the mind-set of a soft-currency country. One day, it willsurely wake up to its true long-term interest.

Notes1. This section draws heavily on Barry Eichen-green, Globalizing Capital: A History of the Internation-al Monetary System (Princeton, NJ: University Press,1996).

2. James Boughton, “A New Bretton Woods?”Finance and Development, March 2009.

3. U.S. Treasury Department, as of March 2009.See http://www.treas.gov/tic/mfh.txt.

4. For accounts of the causes of the crisis, see BennSteil, “Lessons of the Financial Crisis,” CouncilSpecial Report no. 45, Council on Foreign Relations,March 2009; and Lawrence H. White, “How Did WeGet Into This Financial Mess?” Cato InstituteBriefing Paper no. 110, November 18, 2008.

5. The phrase “Great Recession” has been popular-ized by Martin Wolf in his columns in the FinancialTimes. See “What the G2 Must Try to Discuss NowThat the G20 is Over,” Financial Times, April 8,2009.

6. See IMF, http://www.imf.org/external/np/exr/facts/sdr.htm.

7. A. R. Ghosh, M. Chamon, C. Crowe, J. I. Kim,and J. Ostry, “Coping With the Crisis: PolicyOptions for Emerging Market Growth,” IMF StaffPosition Paper, April 2009.

8. H. S. Cheng, FRBSF Economic Letter, FederalReserve Bank of San Francisco, March 7, 1980.

9. Zhou Xiaochuan, “Reform the InternationalMonetary System,” People’s Bank of China, March23, 2009, http://www.pbc.gov.cn/english/detail.asp?col=6500&id=178.

10. Fred Bergsten, “We Should Listen to Beijing’sCurrency Idea,” Financial Times, April 9, 2009.

11. For a review of some of the high costs related toChina’s exchange rate and monetary policies,including the misallocation of capital, see JohnGreenwood, “The Costs and Implications of PBC

13

Sterilization,” Cato Journal 28, no. 2 (Spring/Summer2008); and James A. Dorn, “Ending Financial Re-pression in China,” Cato Institute Economic Devel-opment Bulletin no. 5 (January 26, 2006).

12. See William Jacobson and Ernest Preeg, Letterto the Editor, Financial Times, April 13, 2009.

13. Fred Bergsten, Letter to the Editor, FinancialTimes, April 22, 2009. Also see Arvind Subraman-ian, “Is China Having it Both Ways?” Wall StreetJournal, March 25, 2009.

14. Wolf. See also Warren Coats, “Time For a NewGlobal Currency?” Berkeley Electronic Press 3, issue1 (2009); and Arvind Subramanian, “Imbalancesand Undervalued Exchange Rates: Rehabilitating

Keynes” (post on Financial Times’ EconomistsForum, November 9, 2008).

15. Wolf.

16. Bennett T. McCallum, “China, the U.S. Dollar,and SDRs” (paper presented at the meeting of theShadow Open Market Committee, Cato Institute,April 24, 2009).

17. Guido Mantega, International Monetary andFinancial Committee, International Monetary Fund(statement by the minister of finance of Brazil, April25, 2009), p. 5, http://204.180.229.21/External/spring/2009/imfc/statement/eng/bra.pdf.

18. Caijing.com, April 2, 2009.

14

STUDIES IN THE CATO INSTITUTE POLICY ANALYSIS SERIES

639. Broadcast Localism and the Lessons of the Fairness Doctrine by John Samples (May 27, 2009)

638. Obamacare to Come: Seven Bad Ideas for Health Care Reformby Michael Tanner (May 21, 2009)

637. Bright Lines and Bailouts: To Bail or Not To Bail, That Is the Questionby Vern McKinley and Gary Gegenheimer (April 21, 2009)

636. Pakistan and the Future of U.S. Policy by Malou Innocent (April 13, 2009)

635. NATO at 60: A Hollow Alliance by Ted Galen Carpenter (March 30, 2009)

634. Financial Crisis and Public Policy by Jagadeesh Gokhale (March 23, 2009)

633. Health-Status Insurance: How Markets Can Provide Health Securityby John H. Cochrane (February 18, 2009)

632. A Better Way to Generate and Use Comparative-Effectiveness Researchby Michael F. Cannon (February 6, 2009)

631. Troubled Neighbor: Mexico’s Drug Violence Poses a Threat to the United States by Ted Galen Carpenter (February 2, 2009)

630. A Matter of Trust: Why Congress Should Turn Federal Lands into Fiduciary Trusts by Randal O’Toole (January 15, 2009)

629. Unbearable Burden? Living and Paying Student Loans as a First-Year Teacher by Neal McCluskey (December 15, 2008)

628. The Case against Government Intervention in Energy Markets: Revisited Once Again by Richard L. Gordon (December 1, 2008)

627. A Federal Renewable Electricity Requirement: What’s Not to Like?by Robert J. Michaels (November 13, 2008)

626. The Durable Internet: Preserving Network Neutrality without Regulation by Timothy B. Lee (November 12, 2008)

625. High-Speed Rail: The Wrong Road for America by Randal O’Toole (October 31, 2008)

624. Fiscal Policy Report Card on America’s Governors: 2008 by Chris Edwards(October 20, 2008)

623. Two Kinds of Change: Comparing the Candidates on Foreign Policyby Justin Logan (October 14, 2008)

622. A Critique of the National Popular Vote Plan for Electing the President by John Samples (October 13, 2008)

621. Medical Licensing: An Obstacle to Affordable, Quality Care by Shirley Svorny (September 17, 2008)

620. Markets vs. Monopolies in Education: A Global Review of the Evidenceby Andrew J. Coulson (September 10, 2008)

619. Executive Pay: Regulation vs. Market Competition by Ira T. Kay and StevenVan Putten (September 10, 2008)

618. The Fiscal Impact of a Large-Scale Education Tax Credit Program by Andrew J. Coulson with a Technical Appendix by Anca M. Cotet (July 1, 2008)

617. Roadmap to Gridlock: The Failure of Long-Range Metropolitan Transportation Planning by Randal O’Toole (May 27, 2008)

616. Dismal Science: The Shortcomings of U.S. School Choice Research andHow to Address Them by John Merrifield (April 16, 2008)

615. Does Rail Transit Save Energy or Reduce Greenhouse Gas Emissions? by Randal O’Toole (April 14, 2008)

614. Organ Sales and Moral Travails: Lessons from the Living Kidney Vendor Program in Iran by Benjamin E. Hippen (March 20, 2008)

ANNE APPLEBAUMWASHINGTON POST

GURCHARAN DASFORMER CEO, PROCTER

& GAMBLE, INDIA

ARNOLD HARBERGERUNIVERSITY OF CALIFORNIA

AT LOS ANGELES

FRED HUGOLDMAN SACHS, ASIA

PEDRO-PABLO KUCZYNSKIFORMER PRIME MINISTER OF PERU

DEEPAK LALUNIVERSITY OF CALIFORNIA

AT LOS ANGELES

JOSÉ PIÑERAFORMER MINISTER OF LABOR AND

SOCIAL SECURITY, CHILE

T he Center for Global Liberty and Prosperity was established to promotea better understanding around the world of the benefits of market-lib-eral solutions to some of the most pressing problems faced by develop-

ing nations. In particular, the center seeks to advance policies that protect humanrights, extend the range of personal choice, and support the central role of eco-nomic freedom in ending poverty. Scholars in the center address a range of economic development issues, including economic growth, international finan-cial crises, the informal economy, policy reform, the effectiveness of official aid agencies, public pension privatization, the transition from socialism to the mar-ket, and globalization.

For more information on the Center for Global Liberty and Prosperity, visit www.cato.org/economicliberty/.

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“The Benefits of Port Liberalization: A Case Study from India” by Swaminathan S. Anklesaria Aiyar,Development Policy Analysis no. 7 (December 3, 2008)

“Zimbabwe: From Hyperinflation to Growth” by Steve H. Hanke, Development Policy Analysis no. 6(June 25, 2008)

“A Decade of Suffering in Zimbabwe: Economic Collapse and Political Repression under RobertMugabe” by David Coltart, Development Policy Analysis no. 5 (March 24, 2008)

“Fifteen Years of Transformation in the Post-Communist World: Rapid Reformers OutperformedGradualists” by Oleh Havrylyshyn, Development Policy Analysis no. 4 (November 9, 2007)

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