A Currency System for a Multi-Polar World
The recent drama over whether the United States would default has weakened confidence in the American economy and underscored the already growing desire of many investors around the world, including many central bankers, for more diversity in their portfolios. Indeed, even policymakers in the United States might agree that the US dollar is vastly over-weighted, with an estimated 60 percent share of foreign exchange reserves. The euro has about a 25 percent share, which is modestly larger than the euro area’s share of world GDP; and most other currencies have shares lower than their countries’ shares of world GDP.1 The problem is that Europe and Japan also have serious fiscal problems, and no other country is seen as having financial markets sufficiently large and sophisticated to take on a major role.
There is an obvious alternative, however: the special drawing right (SDR) issued by the International Monetary Fund (IMF). True, the SDR can never be an international currency in all respects unless countries are willing to cede monetary sovereignty to the IMF and join a global common currency union.2 That day will not happen in the foreseeable future and may never happen. Indeed, my forthcoming book with Marc Hinterschweiger, Flexible Exchange Rates for a Stable World Economy, amply demonstrates the high economic costs of fixing exchange rates between countries that are not committed to complete economic and political union.3
Nevertheless, the SDR can be at the heart of a strategy to redress the asymmetry of international reserve assets and to satisfy the demands of diversity-seeking investors. Toward that end, I propose that the IMF take two related actions: First, expand the SDR basket to include the currencies of all countries that have sound macroeconomic policies and whose bond markets meet minimum standards of openness and supervision; second, create synthetic SDR bonds backed by medium-term sovereign bonds denominated in the currencies of the SDR basket.
Expanding the SDR Basket
Size should not be a criterion for inclusion in the SDR basket. All currencies of countries with low and stable inflation, sound monetary, fiscal, and supervisory policies, and open financial markets should be included in the SDR basket. A minimum standard of openness is that there should be no quantitative restrictions on foreign purchases of a country’s bonds and any tax on capital flows should not exceed a moderate rate. At present, it is likely that several dozen countries would qualify for inclusion in the SDR, including almost all advanced countries and a number of developing countries. The composition of the SDR basket should be revisited every few years, as is the current practice. The weights should be based on GDP at market prices and exchange rates, although other weighting schemes might be considered.
A recent IMF staff report (IMF 2011) acknowledges the benefits of a broader SDR basket for reserve diversification and for financial development in emerging markets. It then suggests that adding too many currencies with low weights would increase risks and transactions costs excessively. In practice, however, diversification would reduce risks and the selection criteria proposed here would exclude bonds that are particularly risky. Moreover, as discussed below, having the IMF create the SDR bonds for all investors would give rise to considerable economies of scale, thereby minimizing transaction costs associated with a large SDR basket.
Creating SDR Bonds
The second part of the proposal is for the IMF to create synthetic SDR bonds that are backed by sovereign debt in the currencies of the SDR basket.4 Initially, the SDR bonds would focus on a 3-year maturity by limiting the underlying assets to bonds with remaining maturity of 2.5 to 3.5 years at the time of creation. The SDR bonds would be identified by vintage dates for the year and semester (or quarter) in which they are created. The range of maturities could be expanded over time based on market demand.
These SDR bonds would be similar to exchange-traded funds (ETFs) and could be traded among investors as ETFs are. In addition, the IMF would perform a role similar to an ETF manager in creating or liquidating the synthetic SDR bonds to keep their market value close to the net asset value of the underlying bonds. Purchases and redemptions would be conducted in any of the major international currencies, including at least the four largest currencies by trading volume: the US dollar, the euro, the yen, and the UK pound (BIS 2010). As is the practice with ETFs, the IMF would take a small slice of the returns on the underlying bonds to cover its costs. The IMF would not guarantee the performance of the SDR bonds, but the selection criteria and diversification would ensure that SDR bonds are very high-grade instruments.
This proposal should not be confused with that of the "substitution account," which was proposed (but never adopted) in the 1970s to facilitate off-market swaps of dollars for SDRs that would have exposed the IMF to considerable exchange rate risk (Boughton 2001, Chapter 18).
Advantages of SDR Bonds
The primary purchasers of SDR bonds, at least initially, are likely to be central banks and finance ministries. Indeed, the use of SDR bonds for foreign exchange reserves would appear to answer the calls of Russian finance minister Alexei Kudrin for a greater reserve currency role of the ruble and the yuan5 as well as Chinese central bank governor Zhou Xiaochuan (2009) for an expansion of the SDR basket and the issuance of more SDR assets. Moreover, Article VIII of the IMF Articles of Agreement obliges all members to "collaborate with the Fund and with other members … [in] making the special drawing right [SDR] the principal reserve asset in the international monetary system."
SDR bonds would make the international monetary system more symmetric. They would provide investors, including central banks, with a standardized asset that provides both a high degree of diversification and a deep and liquid market. SDR bonds would reduce the distortions caused by excessive reliance on the US dollar as the main reserve asset. Perhaps most importantly, they would provide an incentive for sound macroeconomic and financial policies in developing economies and they would assist in the development of local currency bond markets in these economies, thereby reducing the need to borrow in foreign currencies, which gives rise to dangerous currency mismatches.
SDR bonds would become the world’s premier reserve asset, but this would not prevent central banks from holding a fraction of their reserves in specific currencies, as a hedge against liabilities denominated in those currencies or because a high share of their imports is priced in those currencies.
The IMF Role Is Essential
In principle, central banks and institutional investors already are able to construct diversified portfolios that do not rely inordinately on one or two key currencies. In practice, the weight of precedent is heavy and the markets of the established key currencies have an enormous advantage in liquidity and transactions costs. No individual central bank or investor can hope to change these conditions. Moreover, any divergence of investment policies from prevailing norms exposes a central bank to criticism and confusion about its motives and its competence. Without a common global standard, there will never develop a secondary market for synthetic combinations of sovereign bonds.
Only the IMF, with the support of its members, can lead the world to a better outcome. No other institution has the expertise and the impartiality to choose the composition of the new SDR basket. The IMF is uniquely placed to assess its members’ financial market conditions and macroeconomic policies—these are the focus of regular Article IV consultations with all member countries. In creating the primary reserve asset for most of the world’s central banks, the IMF would benefit from unparalleled economies of scale and knowledge of its customers.
BIS. 2010. Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity. Basel: Bank for International Settlements.
Boughton, James. 2001. Silent Revolution: The International Monetary Fund 1979-89. Washington: International Monetary Fund.
Gagnon, Joseph, and Marc Hinterschweiger. 2011. Flexible Exchange Rates for a Stable World Economy. Washington: Peterson Institute for International Economics, forthcoming.
IMF. 2011. Enhancing International Monetary Stability—A Role for the SDR? Washington: International Monetary Fund, January 7.
Zhou, Xiaochuan. 2009. Reform the International Monetary System. Essay on the website of the People’s Bank of China, March 23.
1. Share data are from the IMF’s Currency Composition of Official Foreign Exchange Reserves (2011Q1) and are based on reserves for which currency composition is reported. About 45 percent of all reserves are held by countries that do not report the currency composition of reserves.
2. IMF (2011) reviews the difficulties associated with issuing more official SDRs and promoting use of the SDR as a unit for the pricing of international trade.
3. Indeed, as the ongoing fiscal crisis in the euro area demonstrates, these costs may be high even when countries have committed to a large degree of economic and political union.
4. IMF (2011) suggests that the IMF might issue more bonds denominated in SDRs for its own funding needs, but the scope for such issuance is much more limited than for the synthetic SDR bonds proposed here.
5. Toni Vorobyova and Guy Faulconbridge, "Russia says yuan could be reserve currency in decade," Reuters, June 6, 2009.