Introduction:

As the topic” creation of SDR and its role in solving liquidity problem” suggests, we are

going to look in the past that what was the purpose behind creation of SDR, the various

stages which it went through what is its present position and how far is it serving the

purpose for which it was created ie; to look after the liquidity crunch.

From the inception of International Monetary System (I.M.S.) the system has been facing

liquidity problem. Starting with the gold standard, the limited stock of gold could not

cope with the increasing world trade. The introduction of the gold-exchange standard

which included some key currencies as the American dollar, the British pound sterling,

German mark, French franc and Swiss franc. This experiment did not meet the increasing

world trade and with economic and political dominance of America, the I.M.S. shifted to

what in many circles became the "pure dollar system". As more developing countries

joined the system and with the increasing dependency of the system on U.S. balance of

payments deficit, the I.M.F. decided to introduce the Special Drawing Right (S.D.R.) as a

reserve currency.

Ever since its introduction, the S.D.R. has met stiff resistance particularly by the U.S.A.

This study has examined the potential of the SDR serving as a reserve asset which can

serve the interest of all countries and free it from particular countries' political influence.

The paper concludes that despite the resistance of the U.S. and its allies, as the economies

of developing countries match those of the developed countries, the S.D.R. stands a good

chance of becoming an acceptable reserve currency of the Fund

But before going into details, let’s have a look at some of the basics concerning SDR.

What is SDR?

SDR is an international type of monetary reserve currency, created by the International

Monetary Fund (IMF) in 1969, which operates as a supplement to the existing reserves of

member countries. Created in response to concerns about the limitations of gold and

dollars as the sole means of settling international accounts, SDRs are designed to

augment international liquidity by supplementing the standard reserve currencies.

SDRs could be regarded as an artificial currency used by the IMF and defined as a

"basket of national currencies". The IMF uses SDRs for internal accounting purposes.

SDRs are allocated by the IMF to its member countries and are backed by the full faith

and credit of the member countries' governments.

History of SDRs:

The Origins of the SDR Department The SDR Department was established in 1969 when the international financial system

was still based upon the gold standard and fixed exchange rates to address short-term

imbalances. It was feared that the slow rate of gold production would limit the growth of

international reserves and lead to either a devaluation of the US dollar or constraints on

international trade. As a solution, the IMF would print SDRs or “paper gold” and

allocate them among its members. Governments would agree to accept SDRs at a fixed

rate of SDR 35 per ounce of gold. The IMF would create SDRs whenever there was

deemed to exist a “long-term global need to supplement existing reserve assets.”3 The

SDR was to become the primary reserve medium in the international monetary system.

When the Bretton Woods system collapsed in 1971-73 and the world moved to a system

of floating exchange rates, the rationale for SDR creation disappeared. The SDR

Department found a new function: it morphed into a foreign aid mechanism to transfer

money from rich to poor countries.

Quotas provide the vast majority of IMF resources and are familiar to Congress which

authorizes periodic additional funding, most recently in 1998. These finance the General

Department where IMF lending takes place. The SDR Department is completely separate

and has been provisioned by General Allocations of SDRs distributed in proportion to

IMF quotas. To date, there have been two General Allocations totaling SDR 21.4 billion

(US$ 31 billion at current exchange rates): SDR 9.3 billion in 1970-72 and SDR 12.1

billion in 1978-81.

The SDR was introduced by the IMF in 1970 to boost world liquidity after the ratio of

world reserves to imports had fallen by half since the 1950s. Through book-keeping

entries, the Fund allocated SDRs to member countries in proportion to their quotas.

Countries in need of foreign currency may obtain them from other central banks in

exchange for SDRs.

SDRs were first allocated in 1970 equal to 1/35 of an ounce of gold, or exactly $1

($1.0857 after the dollar was devalued in 1971). When the dollar came off the gold

standard the SDR was fixed from 1974 in terms of a basket of 16 currencies. This proved

too unwieldy and in 1981 the basket was slimmed to five major currencies with weights

broadly reflecting their importance in international trade (see Table).

Since 1981 the IMF has paid the full market rate of interest on the SDR, based on a

weighted average of rates paid by the individual constituents.

Currencies in the SDR %country currency 1981-85 1986-90 1991US dollar 42 42 40Germany D- mark 19 19 21Japan yen 13 15 17France franc 13 12 11UK pound 13 11 11

Composition of SDR

Period  

USD 

DEM JPY

 GBP

 FRF

1981-19850.540 (42%)

0.460 (19%)

34.0 (13%)

0.0710 (13%)

0.740 (13%)

1986–19900.452 (42%)

0.527 (19%)

33.4 (15%)

0.0893 (12%)

1.020 (12%)

1991–19950.572 (40%)

0.453 (21%)

31.8 (17%)

0.0812 (11%)

0.800 (11%)

1996–19980.582 (39%)

0.446 (21%)

27.2 (18%)

0.1050 (11%)

0.813 (11%)

After the introduction of Euro:

Period  USD  EUR  JPY  GBP

1999–20000.5820 (39%)

0.3519 (32%) 27.2 (18%) 0.1050 (11%)

2001–20050.5770 (45%)

0.4260 (29%) 21.0 (15%) 0.0984 (11%)

2006–20100.6320 (44%)

0.4100 (34%) 18.4 (11%) 0.0903 (11%)

How the SDR Department Works

SDR allocations initially create credit balances in each member’s account in the SDR

Department. Each country pays interest on its allocation and receives interest on its

credit balance at the same SDR floating interest rate. The SDR interest rate is a weighted

average of the yields on specified risk-free short-term instruments in the US, UK,

European and Japanese money markets whose currencies compose the SDR. The US

dollar component is the three-month US Treasury bill.

When a country exchanges its allocated SDRs for freely usable currencies, the

government’s credit balance falls below its allocation. The country has borrowed the

difference between its allocation and its credit balance at the SDR interest rate. When a

country accepts additional SDRs in exchange for freely usable currencies, its credit

balance rises above its allocation. The country has lent the excess of its credit balance

over its allocation at the SDR interest rate. If a country does not use its SDRs and does

not accept SDRs in exchange for freely usable currencies, its credit balance equals its

allocation and it has no cost or benefit because the interest payments received and paid

exactly offset each other.

Us dollar per SDR:

Now we are going to compare the world’s strongest currency against SDR.

As this chart shows, while the Dollar lost almost half of its value against the Euro since

2002, it has lost "only" one-third against the unreal, intangible SDR.

Most of the difference comes thanks to the Japanese Yen also losing favor against the

Pound and the Euro – the other two members of the SDR basket. But they in turn keep

losing value against the goods and services people actually use them to buy.

"Monetary gold and SDRs issued by the IMF are financial assets for which there are no

corresponding financial liabilities," as the Monetary Fund says. But while the SDR is an

intangible monetary unit that only holds value when turned into Dollars, Euros, Yen or

Pounds Sterling.

Uses of SDR:

SDRs are used as a unit of account by the IMF and several other international

organizations.

A few countries peg their currencies against SDRs, and it is also used to

denominate some private international financial instruments.

SDRs acts as credits that nation with balance of trade surpluses can 'draw' upon

nations with balance of trade deficits.

Eliminates the logistical and security problems of shipping gold back and forth

across borders to settle national accounts.

SDRs are the basis for the international fees of the Universal Postal Union,

responsible for the world-wide postal system.

SDRs are also used to transfer roaming charge files between international mobile

telecoms operators and charges for some radio communications.

SDRs limit carrier liability on international flights as well as ship owner liability

for cargo damages and oil pollution.

In Europe, the Euro is displacing the SDR as a basis to set values of various

currencies

SDR and world liquidity:

We have already covered the basics about SDRs. Now we will analyze how far SDRs

have been successful in solving the world liquidity problem? SDRs were mainly created

so that the emerging economies didn’t face any liquidity crunch. The emerging

economies were in main need of capital, so we will see whether the SDRs were able to

meet their needs or not?

The SDR Department is an arcane system of financing that was designed to address a

potential global shortage of international reserves. Now, it has been transformed into a

redistribution mechanism that compels rich countries to lend on demand to poor nations

at a highly subsidized floating interest rate--the weighted average of the lowest short-term

interest rates in the world. The United States is the chief source of these perpetual and

unconditional loans.

The volatility of private capital flows:

Private capital flows have been highly volatile, and emerging market economy countries

have proved very vulnerable to the instability of private expectations.

In recent years, considerable efforts have gone into analyzing financial crises and

formulating macroeconomic and financial policies for preventing crises. A review of past

crises reveals that underlying macroeconomic vulnerabilities—overvalued exchange

rates, a high level of short-term debt relative to international reserves, large current

account deficits, sharp declines in terms of trade, undercapitalized and poorly supervised

financial institutions—often contribute to crises.

The Problem of Negative Capital Flows to Emerging Economies

Despite efforts to prevent the decline in capital flows, over the past few years resource

flows to emerging markets have turned negative. As a group, emerging market economies

became net exporters of capital to industrial countries, running large surpluses on the

current account in both 2000 ($128 billion) and 2001 ($70 billion). Moreover, both the

Bank for International Settlements and the International Monetary Fund (IMF) expect a

sharp fall in lending to these countries in the coming months, so these countries may well

be capital exporters again in 2002.

Faced with a slowdown in the international economy and the resulting decline in

exports, these countries have to retrench, in order to protect themselves from the risk of a

financial crisis. Particularly at a time when the market’s appetite for risk has diminished

markedly.

Experience has shown that financial crises could have been avoided if a

country has ample international liquidity, whether in the form of high levels of

International reserves or external support in the form of very large, readily available lines

of credit that would have allowed it to correct any external imbalances in an orderly

fashion. For this reason, countries were often advised to increase their reserves. This

policy prescription led China, Hong Kong (China), the Republic of Korea, Singapore,

Taiwan (China), and other Asian economies to hold very high levels of international

reserves.

The IMF’s poor performance reflected the fact that when countries are

subject to speculative attacks, IMF loans are not unconditional and immediately

available, so the market did not knew for certain how much support will be available.

Furthermore, with usable resources of just 110–120 billion Special Drawing Rights

(SDRs), the total assistance the IMF offered was not sufficient to deal with the

needs of several large countries at the same time.

Scenario during past few years:

If we consider briefly the few years back international economic situation. The

international economy was in the midst of a recession and the rate of growth of

international trade declined. Faced with a recession, major industrial countries

adopted expansionary fiscal or monetary policies or both to try to stimulate recovery. In

contrast, when demand for the exports of developing and emerging market economies

declined often with more than proportional effects on export revenues—these countries

retrenched and couldn’t resort to expansionary policies to avoid a financial

crises.

Moreover, recently the two main sources of international liquidity contracted,

hindering recovery in these economies. Financial market flows for developing countries

declined or dried up, causing capital flows in many of these countries to turn negative, as

mentioned earlier. The other main source of international liquidity, the U.S. deficit on the

current account, also contracted significantly.

One of the purposes of the IMF is “to facilitate the expansion and balanced

growth of international trade, and to contribute thereby to the promotion and maintenance

of high levels of employment and real income and to the development of the productive

resources of all members as primary objectives of economic policy” (Article I (ii),

Articles of Agreement of the IMF). When faced with a recession, the authorities in

industrial countries generally try to expand demand, often by expanding liquidity. The

international community can also counter contractionary forces by expanding liquidity.

IMF’s focus on Expansion of International Liquidity by Allocating SDRs

In keeping with its purpose, the IMF could and perhaps should contribute to financial

stability and the promotion of international trade by allocating SDRs to stimulate

economic recovery during an international recession. Expansion of international liquidity

through the issue of SDRs requires an 85 percent majority vote. In the past, some

industrial countries have opposed even modest allocations of SDRs on the grounds that

they would be inflationary. Today, in the face of a widespread recession, a decline in the

rate of growth of international liquidity, and the need to expand liquidity to support the

expansion of international trade, it would be very difficult to make that argument. There

would thus appear to be a strong case for supplementing the creation of liquidity and

meeting the needs of the international economy by allocating SDRs.

Under the Articles of the IMF, SDRs are allocated to member countries in

proportion to their quotas. Thus the G-7 would receive more than 47 percent of any

allocation, and industrial countries as a group would receive 61 percent. However,

recipient countries may donate their SDRs to developing and emerging economy

countries or to a trust fund to benefit eligible countries (that is, countries that are prepared

to invest the funds in capacity-building projects and to adopt appropriate policies).

Recipients of SDRs would, of course, cover the interest on the funds received at

the SDR rate of interest, the weighted average of the short-term Treasury bill rates of

France, Germany, Japan, the United Kingdom, and the United States (currently 2.25

percent a year). Recipient countries, which in most cases have little access to financial

markets and then only at much higher rates, would find these terms very attractive. As

recipient countries experienced an improvement in their reserve position, they would be

able to sustain higher levels of investment and imports, with the consequent increase in

economic activity and international trade. Allocating SDRs would thus also help avert

new financial crises.