The SDR Goes the Way of the Renminbi

The International Monetary Fund's decision to add the Chinese renminbi to the basket of currencies that compose the Special Drawing Right (SDR) at the end of November 2015 was no small choice. Set to take effect October 1 this year with a weight of 10.92 percent versus the total basket, the inclusion of the renminbi has potential to make the SDR's US dollar value more volatile.

The IMF, in a 2011 paper [PDF] examining potential roles for the SDR in enhancing global monetary stability, suggests its use as a unit of account (for example, to price global trade, peg currencies, or denominate financial assets) could "reduce the impact of exchange rate swings" by virtue of its basket characteristics. In this way, the SDR can function as a hedge against the volatility of the other major currencies vis-à-vis the dollar. With the addition of the renminbi, this may not be the case, at least for some time. The medium-term effect will essentially be to increase the dollar's weight.

Historically, the renminbi has tended to closely track the dollar, so adding it to the basket can be seen as having a similar effect as increasing the dollar's weight (thereby lowering the volatility of the SDR). As China continues feeling out its path towards a more flexible exchange rate regime, this relationship will gradually change.

With these facts in mind, it is useful to examine the dollar value (XDR/USD) of the new basket, and its volatility, under alternative scenarios. Table 1 gives the weights for each currency assigned in the IMF's most recent review on November 30, 2015,¹ as well as the current weights. As stated, the 2016 weights will come into effect October 1. The alternative weights follow the IMF's methodology² but remove the renminbi and adjust the 2016 weights upward proportionally.

Sources:IMF and author's calculations.

Figure 1 shows the dollar value of the SDR in terms of the 2016 SDR weights (5-currency basket) and the alternative weights (4-currency basket), comparing them with the actual dollar value of the SDR over the past five years. Based on the past five years, the chart provides an educated picture of the future dollar price of the SDR under the new 5-currency basket. The new SDR basket deviates from the actual XDR/USD value principally because of the upward drift of the renminbi over this period, raising the dollar price of the SDR. A hypothetical 4-currency basket (no renminbi) closely tracks the course of the SDR with the current basket, as evident in figure 2.

Figure 1 Dollar value of the SDR, 2010-15

Sources: Bloomberg, IMF, and author's calculations.

Although the new 5-currency basket diverges from the historical SDR dollar value, it is critical to put this into perspective. Figure 2 indexes both the actual 5-currency and hypothetical 4-currency baskets to the dollar price of the SDR. It is apparent that in terms of levels, neither the 4- nor 5-currency basket will deviate substantially from the current dollar price of the SDR, rising some 3 percent in early 2015 because of the renminbi's appreciation through that time, and declining more recently as it has depreciated.

Figure 2 Levels of baskets, SDR = 1

Sources: Bloomberg, IMF, and author's calculations.

However, these data in terms of levels say nothing of the variability of each basket.

When measured in 200-day rolling standard deviations (figure 3) the differences in the volatility of the actual 5-currency and hypothetical 4-currency baskets become immediately evident. From end-2010 through early January (which includes the recent dollar appreciation), the renminbi-inclusive basket exhibits lower standard deviations than the 4-currency basket or the dollar price of the SDR. This is consistent with the hypothesis that adding the renminbi to the SDR basket is similar to increasing the dollar's weight, because it reduces the standard deviation against the dollar. This historically stable relationship may well shift as China transitions towards a more freely floating regime, with less weight placed on the dollar in its own exchange rate policy.

Figure 3 200-day rolling standard deviations

Sources: Bloomberg, IMF, and author's calculations.

Table 2 illustrates this point in a wider manner, reporting a lower standard deviation for the rolling 200-day window, 90-day window, and full period of the renminbi-inclusive basket. T-statistics close to zero for the full-period renminbi-inclusive basket against the XDR/USD and 4-currency basket against the XDR/USD give further evidence that the low standard deviations of the two baskets are not significantly different from the XDR/USD. Significance tests for the 90- and 200-day rolling series against the XDR/USD give similar results, essentially zero for the 5-currency basket and below 0.1 for the 4-currency basket. By these measures, the actual 5-currency and hypothetical 4-currency baskets are an accurate representation of the historical dollar value of the SDR, demonstrating that the addition of the renminbi (under its historical exchange rate policy) reduces the variability of the SDR.

90-day rolling average SD200-day rolling average SDt-statistic (full period)t-statistic 90-day windowt-statistic 200-day window

Full-period SD90-day rolling average SD200-day rolling average SDt-statistic (full period)t-statistic 90-day window

Sources: Bloomberg, IMF, and author's calculations.

This blog has shown that if China were to follow a more flexible exchange rate policy in the future, as is generally expected, the dollar price of the SDR in time may well fluctuate more sharply than in the past. How much volatility will depend on the timing, pace, and decisions made by Chinese authorities. This may have some bearing on the attractiveness of the SDR as a hedging instrument, peg, or denominator of trade and financial flows.

Notes

1. Official SDR currency weights are subject to review and readjustment by the IMF every five years.

2. Each currency's weight in the valuation of the SDR is calculated using a formula that assigns a 50 percent weight to a currency's use in exports, and 50 percent to a financial indicator. The financial indicator comprises international reserves (at a weight of 50 percent), foreign exchange turnover (25 percent), and international banking liabilities and international debt securities, the sum of which is given a weight of 25 percent. See detailed overview of this methodology here [PDF].