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SDR Does Not Stand for Secret Dollar Replacement

TruthAt the IMF/World Bank meetings this week, Chinese officials are again pushing for greater use of the IMF’s unit of account, Special Drawing Rights.   It is China’s turn as the rotating host of the G20, which gives it greater influence over its agenda.
For its part, the IMF is concerned about global financial stability and must be open-minded.  It wants to strengthen the financial system.   It is only prudent to examine all reform ideas.
Last September, the IMF agreed to include the yuan in the SDR as of later this year.  It was seen primarily as a symbolic recognition of how far China’s economy and financial sector has evolved over the last five years.  The desire to join the SDR also encouraged China to proceed with various financial reforms.
China, like several other countries, is critical of what they perceive to be a unipolar world dominated by the US.  Numerous books in recent years claim the US is already in decline, or that the world is experiencing hegemonic stability crisis because it is a “G-Zero” world.  China is a rising power, and it presses demands for accommodation territorially as in the South China Sea, but also in economic and financial matters.
Contrary to some pundits claiming that the Chinese yuan is challenging the dollar, Chinese officials, led by the central bank, have been advocating the use of the SDR to supplement and supplant the central role provided by the US dollar.  Most of the talk seems to have a propaganda value rather than a real impact.
The true internationalization of the yuan, which means that trade and capital flows with its Special Administrative Region (Hong Kong) ought to be considered domestic, is considerably less than the other currencies in the SDR.  This is why many economists were critical of the decision to include the yuan in the SDR.
China has suggested two initiatives this week.  First, China suggests it may issue SDR bonds domestically.   What would they look like?  SDR is a basket of currencies (the new iteration will be 41.73% US dollars, 30.93% euro, 10.92% yuan, 8.33% yen, and 8.09% sterling).    These bonds then would be a particular type of multi-currency bonds.  Multi-currency bonds do exist, but they are not particularly liquid.  Moreover, given that the SDR bond is 89% foreign currency for Chinese investors, purchases of such bonds by domestic investors would be a form of capital outflow.  For institutional investors, hedging could be expensive and operationally complicated.
China has also indicated it will begin publishing its reserve data in terms of SDR.  That is fine and good.  The PBOC could report its reserves any way it wants.  However, the preliminary and partial details of its reserve composition that it recently revealed to the IMF,  it has not matched the SDR composition.  Therefore, reporting the reserves in SDR terms is not an accurate measurement, it is simply a different distortion than reporting them in dollars or yuan.
What about foreign investors buying SDR bonds?  They could if they wanted, but we suspect the investor interest would be limited.  For liability managers, like insurance companies or pensions, the SDR is unlikely to be a good match.  For asset managers, given that the yuan is still so closely linked to the dollar, the yuan’s role can also be ignored.  Operationally the fact that the yuan is still not truly free floating in practice means that the dollar’s effective weighting could be treated as if it were higher not lower.
China is also engaged in a bit of misdirection.   By talking about the SDR, China deflects attention from the more immediately pressing issue.  The IMF is pushing China to provide more information about the central bank’s use of derivatives, such as forward and futures to intervene in the foreign exchange market.  These are old ploys that central banks have used to conceal their operation.  Intervening in the forward or future market would not show up in the current reserve figures.
Money, economists argue, has three functions.  It is a store of value.  It is a unit of account.  It is a means of exchange.  The SDR is not money in this sense.  It is a unit of account.   It is not a store of value.  If one does not think that fiat currencies are sustainable over time, the SDR is a basket of fiat currencies.  Its value is purely a function of the performance of its composite currencies.  It is not a means of exchange.   Individuals and institutions do not price their goods in SDRs.  One cannot pay taxes in SDRs.
Ultimately, Chinese officials seem to misunderstand the nature of the SDR or seem to for mostly propaganda purposes to criticize the role of the dollar in the world economy.  For its part, the IMF need not dismiss out of hand Chinese suggestions, but their reform efforts are better focused elsewhere, including GDP-linked bonds, which some of the folks who codified the so-called Washington Consensus have advocated.

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Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.
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