LSE IDEAS, Konrad Adenauer Stiftung, London 28 October 2015
Ousmène Jacques Mandeng
New Sparta Asset Management and LSE Department of Econonomic History
Ladies and Gentlemen,
I'm delighted to present at this LSE IDEAS Konrad Adenauer Stiftung seminar and most grateful to the organisers for this invitation. The seminar's topic is most timely. Earlier this month, at the IMF Annual Meetings in Lima, it was almost bewildering to witness how universal concerns were about the effect on the international economy of an increase in the policy rate of the Federal Reserve. Those concerns serve as a critical reminder of the old and well known dilemma of using national currencies to manage international liquidity. In my brief remarks I will focus on the IMF Special Drawing Rights (SDRs) arguing that SDRs could usefully serve as a framework to promote greater international currency diversification.
The international monetary system has changed little. This despite the fact that the world economy has changed significantly. The increasing asymmetry between international monetary and real developments complicates greatly international economic policy coordination and possibly constitutes a major source of tension and persistent imbalances. The changing geography of the international economy requires a new mapping of international liquidity to allow orderly balance of payments adjustments. I believe that the integration of emerging markets currencies into the international monetary system represents the most important globalisation challenge.
The Fed has remained largely the only entity that can issue international liquidity. There are too few international liquidity pockets resulting in an undue dependence on the dollar. Despite massive issuance of U.S. liabilities, U.S. general government debt is shrinking relative to world output raising the spectre of safe asset scarcity. This is risky from a precautionary point of view. It undermines confidence to banks and capital market participants that marginal liquidity needs can be adjusted flexibly and respond directly to local needs. However, at the same time, there is a priori no reason to believe that the Fed should accommodate foreign liquidity demand. Nor is there any reason to believe that U.S. liquidity needs are congruent with those of the rest of the world. The case for a multi-currency international monetary system is therefore a strong one.
The upcoming IMF SDR basket valuation review offers an important opportunity to rethink the advantages of international currency diversification. The IMF will need to decide by year-end on the composition and valuation of a new SDR basket. Consideration is now being given to include the renminbi. This would be the first time a net addition of a currency to the basket takes place since inception as a currency basket in 1974 (Table). The hurdles for joining the basket are high. It is a test almost no country can pass. Its relevance is doubtful given the flawed underlying objective of the SDR. The SDR was aimed at substituting the dollar. It has failed miserably to achieve it.
What is the SDR today? The SDR is a reserve asset issued by the IMF and used almost exclusively in transactions with the IMF. It is de facto a credit line. It is not a currency nor a liability of the IMF. The SDR is for all practical purposes a pure form of internal money. Its valuation does not depend on market movements nor does it seemingly affect the market. The SDR basket is currently made of four currencies, the dollar, euro, sterling and yen. There are SDR204 billion SDRs outstanding equivalent to US$280 billion held predominantly by central banks in their accounts in the IMF. The SDR is also a unit of account and all transactions of the IMF are accounted for in SDRs.
The SDR in its current form has added little to the functioning of the international monetary system. This is in part due to the relatively small amount outstanding but also due to its design. It has never acquired properties sufficient to make it attractive for broader use. Additional large allocations, there have only been three general allocations since inception, seems highly unlikely amid resistance among key IMF member countries. It therefore seems highly unlikely that the SDR in or near its current form will have any meaningful impact.
What could the SDR be? The SDR could become a framework for international currency diversification. SDRs as a framework matter if one believes in the importance of formal arrangements to promote international currency adoption. Most commentators suggest that international currencies are driven largely by markets. Prima facie evidence suggests that institutional factors are very important. The colonial sterling zone promoted sterling, the Bretton Woods system the dollar and the European Monetary System the mark. The major international currencies have been inserted it appears by fiat.
The history of reserve currencies further suggests that informal arrangements have been very important. Milton Friedman called those a “gentlemen’s agreement among central banks not to press for conversion […].1 In 2009, U.S. Secretary of State Hillary Clinton notably urged China not to sell its dollar reserves.2 There have been many key occasions were central banks have become critical lenders to back the leading reserve currency. The preservation of currency convertibility has thus often relied on some understanding to forgo conversion.
The SDR could become a formal or part of an informal arrangement. It could help guide decisions by central banks and facilitate coordination for central bank reserve allocations. The very large amounts of foreign exchange reserves, representing US$11,500 billion in June 2015, suggests that any significant change in reserve allocations should be conducted with greatest care.3 Already, central banks exert considerable influence on key government bond markets amid the size of their allocations and very directional buying.
The participation of a currency in the SDR would increase incentives for central banks to make broader reserve allocations. The SDR would provide legal backing for holding the currencies and some central banks may make similar allocations on the basis of hedging their SDR exposure. The basket weights could serve as an index to direct reserve allocation and central banks may choose the SDR basket as a benchmark for their reserve performance.
The SDR as an international framework for orderly currency integration can be done. It depends on the IMF Executive Board and does not require changes in the IMF’s Articles of Agreement. It would make the SDR truly complementary to existing reserve assets and possibly most importantly give a broader range of countries a stake in the SDR and therefore in the system. Naturally, any multiple currency system needs to ponder the advantages of network externalities of using few currencies against the benefits of diversification of using many.
Some international currency diversification has already taken place (Chart 1). But to allow orderly large-scale transformation of the system, a common framework be it formal or informal seems essential.
The introduction of the renminbi is a step in the right direction. However, if the renminbi qualifies the Australian dollar and Canadian dollar and several other currencies of leading emerging markets also could. The fundamental question is whether to move the SDR basket towards greater inclusiveness or not. That was the spirit in the 1970s when it was made up of 16 currencies. A modern SDR basket made of 16 currencies today to allow good regional and international representation seems desirable.
In 1950, the four currencies in the current SDR basket represented 100 percent of foreign exchange reserves. Today it is 93 percent (Chart 2). This does not seem a lot of progress. The SDR basket should evolve from being the keeper of the status quo to become a catalyst for change.
Thank you very much for your attention.
*Draft 28 October 2015, presented in Panel Discussion and Concluding Remarks.
1 Milton Friedman, Real and pseudo gold standard, Journal of Law and Economics, 1961, pp. 66-79. Reference to the gentlemen’s agreement was also attributed to Roy Harrod as “institutionalising the inconvertibility of the reserve currencies”, see e.g. Robert Triffin, Updating the Triffin Plan, in Maxwell Stamp (ed.), Moorgate and Wall Street: A review, Summer 1965.
2 See e.g. The Guardian, China ‘worried’ about safety of US assets, 14 March 2009
3 IMF COFER. Data for June 2015.