Dreaming of SDRs

In March 2009, in the midst of the financial crisis, the normally circumspect governor of China’s central bank made waves. In a speech published on the bank’s website, Zhou Xiaochuan argued that the world needed a "super-sovereign reserve currency" to be managed by the International Monetary Fund (IMF). The influential banker said that an IMF-issued currency would serve as a "light in the tunnel for the reform of the international monetary system."

Zhou’s call was widely interpreted as a jab at the U.S. dollar and the privileges that the United States retains as the issuer of the world’s leading reserve currency. The U.S. Treasury Department dutifully pushed back against the suggestion that the dollar should lose its preeminence. "I think the dollar remains the world’s standard reserve currency. I think that’s likely to continue for a long period of time," said Treasury Secretary Timothy Geithner. For his part, President Barack Obama insisted that the dollar was "extraordinarily strong."

Zhou’s suggestion was, in many respects, less remarkable than it seemed. The IMF already has in place the "super-sovereign" currency that he envisioned. Moreover, it is stated IMF policy that this currency — the awkwardly titled Special Drawing Rights (SDRs) — should become the world’s leading reserve currency. Zhou’s suggestion appeared revolutionary only because of the convoluted history of this would-be global currency.

The idea of an IMF currency emerged in the early 1960s. At that time, a group of leading economists — notably Robert Triffin — was alarmed at what it perceived as a looming liquidity shortage. The Bretton Woods system established at the end of World War II acknowledged the dominant place of the dollar, but it pegged the dollar to gold. Triffin argued that this limited the dollar’s ability to serve as an effective reserve currency. The more dollars the United States pushed into the system, the more doubt there would be about its ability to back the dollar with gold. As John Williamson of the Peterson Institute for International Economics describes it, "The Triffin dilemma posited that the world therefore confronted a choice between running short of liquidity and undermining confidence in the dollar, which was destined sooner or later to produce a crisis."

The solution that financial policymakers hit upon was to have the IMF create a new international reserve currency: the SDR. This new currency’s value would be determined by a basket of widely traded currencies, basically hedging against the risk inherent in any one currency. This basket comprised of the dollar, the yen, the pound, the franc, and the Deutsche mark (the last two were subsequently subsumed by the euro). The first SDRs — more than 9 billion of them — were issued beginning in January 1970. But just as SDRs were appearing, the very reason for their existence seemed to disappear. In 1971, U.S. President Richard Nixon’s administration broke the link between the dollar and gold. Just like that, Triffin’s famous dilemma ceased to be a dilemma, or at least an acute one. Freed from gold, the United States was able to produce as many dollars as it liked, enough to satisfy the world’s demand for reserve holdings.

The SDR, which IMF economists had expected to become a central feature of the world’s monetary system, instead became a bit player. Today, even after a major new issuance in 2009, SDRs constitute less than 4 percent of global reserves and are used almost exclusively in transactions between sovereign governments and the IMF itself.

But as Zhou’s speech suggests, the idea of the SDR assuming a more prominent role persists. Liquidity may not be the problem that policymakers feared in the 1960s, but a dollar-dominated system has other perceived disadvantages. Plenty of observers believe that the dollar’s position gives the United States an unfair economic advantage. French Finance Minister Valéry Giscard d’Estaing famously declared that the United States enjoyed an "exorbitant privilege" by issuing the world’s de facto reserve currency. In economics parlance, that advantage is usually labeled "seigniorage." The significance of this advantage is hotly debated by economists, and some even argue that the United States suffers from the dollar’s preeminence (primarily because it makes exports less competitive).  

A more pronounced concern is that the dollar’s widespread use as a reserve currency has cemented in place an unhealthy and ultimately unsustainable dynamic: The United States has become accustomed to having an ample market for its debt, an expectation that encourages reckless fiscal and economic policies. On this view, this summer’s fight over raising the debt ceiling was just a preview of a reckoning to come. As Zhou argued in his 2009 speech, Triffin’s dilemma hasn’t disappeared after all: The United States cannot supply the world with its reserve currency indefinitely while retaining investors’ confidence.

But there’s no reason that a more balanced global reserve system requires a super-sovereign currency like the SDR. In theory, other currencies could share the burden (or privilege) of providing the world with a reserve currency. There have been some moves in this direction. The euro has made inroads, though as Harvard University economist Robert Cooper has noted, it has significant limitations. Perhaps the most important one is that there are (for the moment, at least) no debt instruments issued directly by European institutions; a central bank that wants to hold euros must hold national debt denominated in euros. As Barry Eichengreen argued recently, the euro’s troubles in any case make it an unattractive alternative to the dollar:

Once upon a time (less than a year ago), it was possible to imagine international-reserve portfolios dominated by the dollar and euro; today, anxious central bankers are desperate for alternatives to both sick currencies.

The problem is that they have nowhere to turn. The gold market is small and volatile. Chinese bonds remain unavailable. Second-tier currencies, like the Swiss franc, the Canadian dollar, and the Australian dollar, are only a slightly larger midget when combined.

Given this bleak landscape, the moment might appear ripe for SDRs to fulfill their original mission. But moving the SDR back to the prominent place it was designed to occupy would be a formidable political and logistical task. At the moment, SDRs can only be held by the IMF, sovereign governments, and a few other official actors (such as the World Bank and the Bank for International Settlements). Private actors cannot hold or trade SDRs, which greatly limits their utility as a reserve currency. For example, governments cannot easily use SDRs to intervene directly in the markets.

There are also far too few SDRs in existence for the unit to make an impression as a reserve currency. "Expanding the volume of official SDRs is a prerequisite for them to play a more meaningful role," acknowledged a recent IMF report. For the SDR to become globally relevant, the IMF’s major shareholders would have to make a concerted decision to regularly issue more, create a better mechanism for exchanging SDRs for other widely traded currencies, and alter the rules about who may hold them.

Even its most enthusiastic backers realize that the SDR will have to enter the ring slowly, gradually displacing the dollar. After Zhou’s headline-grabbing speech, Chinese leaders have decreased the volume and appear content to move slowly on intermediate reforms like including the renminbi in the basket of currencies that determines the SDR’s current value. A more prominent SDR still appears distant. The world may be in the midst of a financial crisis, but there is no consensus that the IMF’s neglected global currency is part of the solution.