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Introduction:

As the topic” creation of SDR and its role in solving liquidity problem” suggests, we are
going to look in the past that what was the purpose behind creation of SDR, the various
stages which it went through what is its present position and how far is it serving the
purpose for which it was created ie; to look after the liquidity crunch.

From the inception of International Monetary System (I.M.S.) the system has been facing
liquidity problem. Starting with the gold standard, the limited stock of gold could not
cope with the increasing world trade. The introduction of the gold-exchange standard
which included some key currencies as the American dollar, the British pound sterling,
German mark, French franc and Swiss franc. This experiment did not meet the increasing
world trade and with economic and political dominance of America, the I.M.S. shifted to
what in many circles became the "pure dollar system". As more developing countries
joined the system and with the increasing dependency of the system on U.S. balance of
payments deficit, the I.M.F. decided to introduce the Special Drawing Right (S.D.R.) as a
reserve currency.

Ever since its introduction, the S.D.R. has met stiff resistance particularly by the U.S.A.
This study has examined the potential of the SDR serving as a reserve asset which can
serve the interest of all countries and free it from particular countries' political influence.
The paper concludes that despite the resistance of the U.S. and its allies, as the economies
of developing countries match those of the developed countries, the S.D.R. stands a good
chance of becoming an acceptable reserve currency of the Fund

But before going into details, let’s have a look at some of the basics concerning SDR.
What is SDR?

SDR is an international type of monetary reserve currency, created by the International


Monetary Fund (IMF) in 1969, which operates as a supplement to the existing reserves of
member countries. Created in response to concerns about the limitations of gold and
dollars as the sole means of settling international accounts, SDRs are designed to
augment international liquidity by supplementing the standard reserve currencies.

SDRs could be regarded as an artificial currency used by the IMF and defined as a
"basket of national currencies". The IMF uses SDRs for internal accounting purposes.
SDRs are allocated by the IMF to its member countries and are backed by the full faith
and credit of the member countries' governments.

History of SDRs:

The Origins of the SDR Department

The SDR Department was established in 1969 when the international financial system
was still based upon the gold standard and fixed exchange rates to address short-term
imbalances. It was feared that the slow rate of gold production would limit the growth of
international reserves and lead to either a devaluation of the US dollar or constraints on
international trade. As a solution, the IMF would print SDRs or “paper gold” and
allocate them among its members. Governments would agree to accept SDRs at a fixed
rate of SDR 35 per ounce of gold. The IMF would create SDRs whenever there was
deemed to exist a “long-term global need to supplement existing reserve assets.”3 The
SDR was to become the primary reserve medium in the international monetary system.

When the Bretton Woods system collapsed in 1971-73 and the world moved to a system
of floating exchange rates, the rationale for SDR creation disappeared. The SDR
Department found a new function: it morphed into a foreign aid mechanism to transfer
money from rich to poor countries.
Quotas provide the vast majority of IMF resources and are familiar to Congress which
authorizes periodic additional funding, most recently in 1998. These finance the General
Department where IMF lending takes place. The SDR Department is completely separate
and has been provisioned by General Allocations of SDRs distributed in proportion to
IMF quotas. To date, there have been two General Allocations totaling SDR 21.4 billion
(US$ 31 billion at current exchange rates): SDR 9.3 billion in 1970-72 and SDR 12.1
billion in 1978-81.

The SDR was introduced by the IMF in 1970 to boost world liquidity after the ratio of
world reserves to imports had fallen by half since the 1950s. Through book-keeping
entries, the Fund allocated SDRs to member countries in proportion to their quotas.
Countries in need of foreign currency may obtain them from other central banks in
exchange for SDRs.
SDRs were first allocated in 1970 equal to 1/35 of an ounce of gold, or exactly $1
($1.0857 after the dollar was devalued in 1971). When the dollar came off the gold
standard the SDR was fixed from 1974 in terms of a basket of 16 currencies. This proved
too unwieldy and in 1981 the basket was slimmed to five major currencies with weights
broadly reflecting their importance in international trade (see Table).
Since 1981 the IMF has paid the full market rate of interest on the SDR, based on a
weighted average of rates paid by the individual constituents.

Currencies in the SDR %


country currency 1981-85 1986-90 1991
US dollar 42 42 40
Germany D- mark 19 19 21
Japan yen 13 15 17
France franc 13 12 11
UK pound 13 11 11

Composition of SDR
   
Period  JPY  GBP  FRF
USD DEM
1981-1985 0.540 0.460 34.0 0.0710 0.740
(42%) (19%) (13%) (13%) (13%)
0.452 0.527 33.4 0.0893 1.020
1986–1990
(42%) (19%) (15%) (12%) (12%)
0.572 0.453 31.8 0.0812 0.800
1991–1995
(40%) (21%) (17%) (11%) (11%)
0.582 0.446 27.2 0.1050 0.813
1996–1998
(39%) (21%) (18%) (11%) (11%)

After the introduction of Euro:

Period  USD  EUR  JPY  GBP


0.5820
1999–2000 0.3519 (32%) 27.2 (18%) 0.1050 (11%)
(39%)
0.5770
2001–2005 0.4260 (29%) 21.0 (15%) 0.0984 (11%)
(45%)
0.6320
2006–2010 0.4100 (34%) 18.4 (11%) 0.0903 (11%)
(44%)

How the SDR Department Works

SDR allocations initially create credit balances in each member’s account in the SDR

Department. Each country pays interest on its allocation and receives interest on its

credit balance at the same SDR floating interest rate. The SDR interest rate is a weighted

average of the yields on specified risk-free short-term instruments in the US, UK,

European and Japanese money markets whose currencies compose the SDR. The US

dollar component is the three-month US Treasury bill.

When a country exchanges its allocated SDRs for freely usable currencies, the

government’s credit balance falls below its allocation. The country has borrowed the

difference between its allocation and its credit balance at the SDR interest rate. When a

country accepts additional SDRs in exchange for freely usable currencies, its credit

balance rises above its allocation. The country has lent the excess of its credit balance

over its allocation at the SDR interest rate. If a country does not use its SDRs and does
not accept SDRs in exchange for freely usable currencies, its credit balance equals its

allocation and it has no cost or benefit because the interest payments received and paid

exactly offset each other.

Us dollar per SDR:

Now we are going to compare the world’s strongest currency against SDR.

As this chart shows, while the Dollar lost almost half of its value against the Euro since
2002, it has lost "only" one-third against the unreal, intangible SDR.

Most of the difference comes thanks to the Japanese Yen also losing favor against the
Pound and the Euro – the other two members of the SDR basket. But they in turn keep
losing value against the goods and services people actually use them to buy.
"Monetary gold and SDRs issued by the IMF are financial assets for which there are no
corresponding financial liabilities," as the Monetary Fund says. But while the SDR is an
intangible monetary unit that only holds value when turned into Dollars, Euros, Yen or
Pounds Sterling.

Uses of SDR:

• SDRs are used as a unit of account by the IMF and several other international
organizations.
• A few countries peg their currencies against SDRs, and it is also used to
denominate some private international financial instruments.
• SDRs acts as credits that nation with balance of trade surpluses can 'draw' upon
nations with balance of trade deficits.
• Eliminates the logistical and security problems of shipping gold back and forth
across borders to settle national accounts.
• SDRs are the basis for the international fees of the Universal Postal Union,
responsible for the world-wide postal system.
• SDRs are also used to transfer roaming charge files between international mobile
telecoms operators and charges for some radio communications.
• SDRs limit carrier liability on international flights as well as ship owner liability
for cargo damages and oil pollution.
• In Europe, the Euro is displacing the SDR as a basis to set values of various
currencies

SDR and world liquidity:


We have already covered the basics about SDRs. Now we will analyze how far SDRs
have been successful in solving the world liquidity problem? SDRs were mainly created
so that the emerging economies didn’t face any liquidity crunch. The emerging
economies were in main need of capital, so we will see whether the SDRs were able to
meet their needs or not?

The SDR Department is an arcane system of financing that was designed to address a
potential global shortage of international reserves. Now, it has been transformed into a
redistribution mechanism that compels rich countries to lend on demand to poor nations
at a highly subsidized floating interest rate--the weighted average of the lowest short-term
interest rates in the world. The United States is the chief source of these perpetual and
unconditional loans.

The volatility of private capital flows:

Private capital flows have been highly volatile, and emerging market economy countries
have proved very vulnerable to the instability of private expectations.
In recent years, considerable efforts have gone into analyzing financial crises and
formulating macroeconomic and financial policies for preventing crises. A review of past
crises reveals that underlying macroeconomic vulnerabilities—overvalued exchange
rates, a high level of short-term debt relative to international reserves, large current
account deficits, sharp declines in terms of trade, undercapitalized and poorly supervised
financial institutions—often contribute to crises.

The Problem of Negative Capital Flows to Emerging Economies

Despite efforts to prevent the decline in capital flows, over the past few years resource
flows to emerging markets have turned negative. As a group, emerging market economies
became net exporters of capital to industrial countries, running large surpluses on the
current account in both 2000 ($128 billion) and 2001 ($70 billion). Moreover, both the
Bank for International Settlements and the International Monetary Fund (IMF) expect a
sharp fall in lending to these countries in the coming months, so these countries may well
be capital exporters again in 2002.

Faced with a slowdown in the international economy and the resulting decline in
exports, these countries have to retrench, in order to protect themselves from the risk of a
financial crisis. Particularly at a time when the market’s appetite for risk has diminished
markedly.
Experience has shown that financial crises could have been avoided if a
country has ample international liquidity, whether in the form of high levels of
International reserves or external support in the form of very large, readily available lines
of credit that would have allowed it to correct any external imbalances in an orderly
fashion. For this reason, countries were often advised to increase their reserves. This
policy prescription led China, Hong Kong (China), the Republic of Korea, Singapore,
Taiwan (China), and other Asian economies to hold very high levels of international
reserves.
The IMF’s poor performance reflected the fact that when countries are
subject to speculative attacks, IMF loans are not unconditional and immediately
available, so the market did not knew for certain how much support will be available.
Furthermore, with usable resources of just 110–120 billion Special Drawing Rights
(SDRs), the total assistance the IMF offered was not sufficient to deal with the
needs of several large countries at the same time.
Scenario during past few years:

If we consider briefly the few years back international economic situation. The
international economy was in the midst of a recession and the rate of growth of
international trade declined. Faced with a recession, major industrial countries
adopted expansionary fiscal or monetary policies or both to try to stimulate recovery. In
contrast, when demand for the exports of developing and emerging market economies
declined often with more than proportional effects on export revenues—these countries
retrenched and couldn’t resort to expansionary policies to avoid a financial
crises.
Moreover, recently the two main sources of international liquidity contracted,
hindering recovery in these economies. Financial market flows for developing countries
declined or dried up, causing capital flows in many of these countries to turn negative, as
mentioned earlier. The other main source of international liquidity, the U.S. deficit on the
current account, also contracted significantly.
One of the purposes of the IMF is “to facilitate the expansion and balanced
growth of international trade, and to contribute thereby to the promotion and maintenance
of high levels of employment and real income and to the development of the productive
resources of all members as primary objectives of economic policy” (Article I (ii),
Articles of Agreement of the IMF). When faced with a recession, the authorities in
industrial countries generally try to expand demand, often by expanding liquidity. The
international community can also counter contractionary forces by expanding liquidity.

IMF’s focus on Expansion of International Liquidity by Allocating SDRs


In keeping with its purpose, the IMF could and perhaps should contribute to financial
stability and the promotion of international trade by allocating SDRs to stimulate
economic recovery during an international recession. Expansion of international liquidity
through the issue of SDRs requires an 85 percent majority vote. In the past, some
industrial countries have opposed even modest allocations of SDRs on the grounds that
they would be inflationary. Today, in the face of a widespread recession, a decline in the
rate of growth of international liquidity, and the need to expand liquidity to support the
expansion of international trade, it would be very difficult to make that argument. There
would thus appear to be a strong case for supplementing the creation of liquidity and
meeting the needs of the international economy by allocating SDRs.
Under the Articles of the IMF, SDRs are allocated to member countries in
proportion to their quotas. Thus the G-7 would receive more than 47 percent of any
allocation, and industrial countries as a group would receive 61 percent. However,
recipient countries may donate their SDRs to developing and emerging economy
countries or to a trust fund to benefit eligible countries (that is, countries that are prepared
to invest the funds in capacity-building projects and to adopt appropriate policies).
Recipients of SDRs would, of course, cover the interest on the funds received at
the SDR rate of interest, the weighted average of the short-term Treasury bill rates of
France, Germany, Japan, the United Kingdom, and the United States (currently 2.25
percent a year). Recipient countries, which in most cases have little access to financial
markets and then only at much higher rates, would find these terms very attractive. As
recipient countries experienced an improvement in their reserve position, they would be
able to sustain higher levels of investment and imports, with the consequent increase in
economic activity and international trade. Allocating SDRs would thus also help avert
new financial crises.