The Case for Annual Special Drawing Right Allocations

Abstract

The special drawing right (SDR) is issued by the International Monetary Fund (IMF). The SDR has the potential to strengthen dramatically the international monetary system. Established in 1969 and allocated twice during its first decade, the SDR was in the institutional closet from 1980 until 2009 when $250 billion in SDRs were allocated to members of the IMF to help address the global financial crisis. In 2021, another $650 billion in SDRs were allocated to help address the Coronavirus pandemic. The SDR has proved itself as a crisis instrument. This paper proposes regular annual SDR allocations.

Introduction

The International Monetary Fund (IMF) is the principal institution of international monetary cooperation. The IMF’s institutional centrality in the post-World War II international economy and financial system rests on two key pillars. First, the IMF’s financial resources are prepositioned, allowing the IMF to expeditiously support a member or the system. The hat does not need to be passed around each time a need arises.

Second, the IMF can allocate special drawing rights (SDRs) to members, enabling each holder to borrow foreign exchange directly from other members. Unless members agree to cancel outstanding SDRs, they are permanent additions to countries’ international reserves unlike currency reserves that, once spent, disappear from the system. The central monetary role for the special drawing right (SDR) is enshrined in the IMF (2020) Articles of Agreement in an obligation, not currently realized, to make the SDR the principal reserve asset of the international monetary system.¹

IMF members have failed to capitalize on the potential of the SDR tool. This paper proposes that members agree to annual SDR allocations. This would strengthen the IMF and international monetary system. The following is based on Truman (2022).

Background

The SDR amendment to the IMF Articles of Agreement was approved in 1969. The SDR was established in 1969 to supplement existing reserve assets and thereby to serve the purposes of the IMF (2020). Those purposes include promoting international cooperation, reducing international balance-of-payments disequilibria, and lending to members in support of adjustment policies that minimize disruptions to national and international prosperity. In other words, the purpose of the SDR is to support the international monetary system and to smooth the international adjustment process.

The SDR was intended to supplement existing reserve assets and support the Bretton Woods regime of fixed exchange rates. In that system, countries established par values against the U.S. dollar which in turn were tied to gold at the fixed price of $35 per ounce. The structure was supported by the U.S. standing ready to sell gold at that price to governments that had acquired U.S. dollars in preventing their exchange rates from appreciating. The U.S. also committed to buy gold from other countries if they needed dollars. The SDR’s establishment came too late to preserve the Bretton Woods exchange rate regime.

The first SDR allocations were in 1970–1972, starting before the U.S. closed its official gold window in August 1971. A second set of allocations was made in 1979–1981 (Table 1). Not until 2009 was there another SDR allocation. It was agreed to in connection with the 2008–2009 global financial crisis and was followed by a fourth allocation in 2021 in connection with the Coronavirus pandemic.²

Table 1 Allocations of Special Drawing Rights: 1970 to 2021

The IMF allocates SDRs to its members in proportion to their paid-in quota subscriptions, recorded on members’ balance sheets as both assets and liabilities of the holder. Countries receive interest on their SDR assets and pay the same rate of interest on their SDR liabilities. To the extent that a country’s SDR holdings exceed its cumulative allocations, it receives net interest and vice versa.³

Members receiving SDRs can transfer them to other members in exchange for one of the five currencies in the SDR-basket valuation to meet their external financial needs.⁴ They also can be used to discharge obligations to the IMF or other members.

Total SDRs outstanding are SDR 660.6 billion, or $845.0 billion at the U.S. dollar value of the SDRs at the end of September 2022. In June 2022, the SDRs’ share of foreign currency reserves plus SDR holdings was 6.8 percent, significantly less than the shares of the U.S. dollar and euro (55 percent and 18 percent, respectively), but 50 percent more than the next largest share: the Japanese yen (IMF, 2022).

SDR allocations in 2009 and 2021 played a useful crisis-management role. Many countries small and large, low- and middle-income, used their SDRs through various mechanisms to relax the external financial constraint on their domestic economic policies and, thus, contributed to global economic and financial adjustment. As the IMF Articles of Agreement (2020) intended, SDR additions to existing reserve assets allowed members to address actual and potential maladjustments in their international payments while avoiding policies destructive to national or international prosperity.

If the SDR is to continue playing its role in addressing economic disruptions, its share of international reserves should be at least maintained. The most direct way of doing so is via annual allocations.

The Case

The case for moderate, regular annual allocations of SDRs has five main elements. First, SDR allocations have zero cost to the recipient country until or unless that country uses its allocation. SDRs are an insurance policy, in the form of a potential line of credit, with a low premium that only kicks in when the policy is activated via a transfer of SDRs to another holder. Second, the cost of an SDR allocation is also low compared with the positive resource costs of ex ante reserve accumulation via borrowing from global financial markets or devoting real resources to generate current account surpluses rather than to domestic investment. Third, from a global perspective, the accumulation of reserves in the form of SDR allocations involves less distortion of the global economic adjustment process than doing so via undervalued currencies and other policies that boost countries’ current account positions.

Fourth, when SDRs are used, they do not disappear from the system. SDRs are outside assets in the sense that the assets cannot be extinguished, except via cancellation. They move around within the system. In contrast, foreign currency reserves disappear from the system once spent on goods and services or to service debts. Clark and Polak (2004) note that this last advantage reduces the systemic risk associated with relying on borrowed reserves in addition to efficiency gains by substituting for other means of accumulating reserves.

Finally, the case for regular annual SDR allocations rests on the additional assumption that on average there is a continuing annual collective demand for increases in international reserves. International reserves consist of foreign currencies, SDRs, reserve positions in the IMF, and gold. Generally, gold is at the bottom of the pile and is excluded from most tallies of total reserves. Reserve positions in the IMF vary with the need for other countries to borrow from the Fund. Increases in those positions are generally offset by reductions in foreign currency holdings except in the case of countries, such as the U.S. or members of the Eurozone, which may provide their own currencies rather than reduce their foreign currency holdings when their quotas are tapped for IMF lending.

Thus, in the absence of an SDR allocation, the annual change in total holdings of foreign currencies is one proxy for the annual demand for increased international reserves. The annual changes in those holdings have different signs and vary in size from year to year. For example, from the end of 2013 to the end of 2021, the total increase was about $1.2 trillion, an annual average of only $155 billion as holdings declined in four of those eight years (IMF, 2022). However, from the end of 2016 to the end of 2021, the total increase was $2.2 trillion, an annual average of $442 billion as holdings rose in all but one of those years.

Prior to the 2021 SDR allocation, the IMF (2021) projected a 13 percent increase in the global demand for international reserves from 2020 to 2025, the midpoint in a range of $1.1 to $1.9 trillion, or $600 billion a year. In 2021, a bit more than 40 percent of the increase projected by the IMF staff was met by the SDR allocation of $650 billion. During the remaining four years of the 12^th basic period (2023–2026), the U.S. Treasury secretary in principle could vote for another $650 billion SDR allocation, or about $175 billion each year, without the prior consent of the U.S. Congress.⁵ This illustrative figure is not extreme. A dozen years ago, Cooper (2010) suggested the possibility of regular annual SDR allocations of $200 billion a year.

It is also possible, but by no means assured, that in the wake of the sanctions applied to Russia following its invasion of Ukraine, countries’ demand for reserves in the form of assets denominated in national currencies will decline and the attractiveness of a neutral asset, such as the SDR, will increase. Time will tell.

The central question in analyses of the demand for increases in international reserves is whether that demand is motivated by (a) the need for additional insurance against an uncertain future, (b) a by-product of mercantilist policies directed toward increasing exports, reducing imports, and running trade and current account surpluses, or (c) a passive response to national and international economic and financial developments.

The literature’s answer to this question is far from definitive. An IMF staff study a few years ago (Ghosh et al., 2016), found support for three hypotheses: precautionary demand against current account crises, precautionary demand against capital account crises, and mercantilism. However, no one explanation dominated their results. In addition, each explanation was more strongly supported in some periods and for some countries more than others.

Analyses of the 2009 and 2021 SDR allocations should provide some fresh answers to these long-standing questions. They should also shed some light on the role of the SDR in smoothing the global adjustment process. Studies of these recent allocations would have to deal with the fact that they were made under crisis circumstances. A trial period of annual SDR allocations under more settled conditions might shed more consistent light on these important issues.

Conclusion

Regular annual SDR allocations are superior to endogenously generated reserves in that they are outside assets that are costless, continually available, reasonably liquid, and reduce pressures on countries to add to their foreign currency reserves by running larger current account surpluses (or smaller deficits) that divert domestic saving from needed domestic investment and distort the international adjustment process.