SDRs

Having been the world's most wildly held reserve currency for decades, the US dollar's dominance in the international monetary system is now being questioned. Zhou Xiaochaun, the governor of the People's Bank of China, argued that the dollar-dominant system caused the exacerbation of global economic imbalance, and it is time to end America's financially privileged status.

Under Mr. Zhou's plan, the amount of “Special Drawing Rights” (SDRs) should be hugely increased. Also, he suggested that the IMF should form an SDR-denominated fund, and that dollar reserves should be freely transferrable to the SDRs. By doing so, SDR assets can be used as foreign exchange reserves, and governments can reduce their risk of dollar exposure.

SDRs are potential claims on the freely usable currencies of IMF members. The SDR, in fact, is not a currency, but rather an IMF unit of account, or fictitious paper assets. For example, when the German government needs Japanese Yen, they could exchange their SDR holdings for it. This transaction would increase the amount of the SDR in the Japanese current account, while decreasing it in Germany's.

Created in 1996, the SDR system aimed to cope with the US dollar crisis brought by the Bretton Wood international monetary system. Before Bretton Wood, the gold played a key role in international monetary transactions. At that time, each currency was backed by a strict gold standard. The quantity of gold worldwide is relatively fixed; while the economies of all participating IMF members as an aggregate are growing. This created an eventual lack of international liquidity. Seeking a way out of this difficult position, the Bretton Wood system was established in 1944 and the era of dollar came. To bolster faith in the dollar, the U.S. agreed to link the dollar to gold at the fixed rate of $35 per ounce of gold. By adapting the US dollor as the international currency, countries avoid liquidity problems and also eliminate the logistical and security problems of shipping gold back and forth across borders to settle national accounts.

There was a fatal, and even ridiculous, paradox called the Triffin dilemma for this system. In this system, the U.S. had to maintain current account surplus to maintain confidence in US dollars. At the same time, U.S. also had to maintain current account deficit in order to meet the need for international liquidity. This dilemma soon caused a disaster in 1969. America's huge current account deficit led to the US government having difficulty in exchanging dollars for gold. Loss of faith in the dollar pushed IMF members to look for an alternative. SDRs were born.

After U.S. unilaterally refused to fulfill their commitment to exchange the dollars into gold in 1973, the Bretton Woods monetary system eventually broke down. However, until today, the U.S. dollar still accounts for 65% of world’s foreign exchange reserves, while the SDR only accounts for less than 1%. In an essay written in March of this year, Mr. Zhou claimed this is the root cause of the current economic disorder, and proposed strengthening existing global currency controls, through the IMF, as a solution. This would involve a gradual move away from the US dollar as a reserve currency, and towards the use of SDRs as a gobal currency reserve.

In fact, the SDR is unlikely to become a reserve currency in the foreseeable future. It would take years to develop SDR money market that is liquid enough to be a reserve asset. Also, the SDR is only backed by agreement, rather than actual assets. Moreover, IMF requires 85% support of their members to strengthen the power of the SDR, and America, with nearly 17% of the votes in the IMF and benefiting most from the dollar-dominant system, will never approve it. In other words, when Uncle Sam says “no”, there is no need for further discussion.