WHAT ARE SPECIAL DRAWING RIGHTS (SDRs)?

The International Monetary Fund (IMF) introduced Special Drawing Rights (SDRs) in 1969 to bolster
its member nations' official reserves. It is the International Monetary Fund's (IMF) accounting unit.

SDRs were initially adopted in 1944 as part of the Bretton Woods fixed exchange rate system, which
saw several nations lock their exchange rates in relation to the US dollar (and, by extension, to gold).
The assumption was that SDRs, which were introduced with a fixed value of 1 SDR to 1 US dollar,
would improve international liquidity at a time when the fixed exchange rate system's future was
uncertain. However, as the Bretton Woods system collapsed in the early 1970s, SDRs were reduced
to a minor function as an international reserve asset, accounting for just a small percentage of global
reserve assets, which are still dominated by the US dollar.
SDRs are neither a currency nor an IMF claim, and they cannot be utilized in market transactions
directly. They are, however, a means for governments to get hard money and may also be used to
repay IMF loans. SDR holders can get hard currency in return for their SDRs by trading them freely
with other members or by the IMF selecting members with high reserves holdings to purchase SDRs
from members in need of reserves. Such transactions do not involve IMF employees engaging with
national authorities, because there are no conditions or policy adjustments to be made.

SDRs are valued using a basket of five currencies: the US dollar, euro, Japanese yen, British pound
sterling, and, as of 2016, the Chinese renminbi. The IMF determines this value every day based on
these five currencies and their daily market exchange rates. There is an SDR Department at the IMF
that manages all SDR transactions. The IMF's General Department, which oversees typical loan
activities, is completely independent from this department.

HISTORY OF SDRs

The ISO 4217 currency code for special drawing rights is XDR and the numeric code is 960. The IMF
developed special drawing rights in 1969 as an asset to be held in foreign exchange reserves under
the Bretton Woods system of fixed exchange rates. Since 1972, the IMF's principal role has been to
serve as the unit of account.

When the US dollar is weak or otherwise inappropriate as a foreign exchange reserve asset, the XDR
rises to prominence. One of its first tasks was to ease a projected monetary shortfall in 1970. The US
maintained a conservative monetary policy at the time, and did not wish to raise the overall amount
of dollars in circulation. The dollar would have been a less attractive foreign exchange reserve asset
if the US had remained on this path. The US altered its previous strategy and provided sufficient
liquidity shortly after XDR allocations began. A potential role for the XDR was deleted in the process.
9.3 billion XDRs were awarded to IMF member countries during the first round of allocations.

The XDR resurfaced in 1978 when many countries were wary of taking on more foreign exchange
reserve assets denominated in U.S. dollars.

The third round of XDR allocations happened in 2009 and 2011, coinciding with the financial crisis of
2007–08. The United Nations proposed giving XDRs to developing nations in 2001 as a cost-free
alternative to borrowing or running current account surpluses for building foreign exchange reserves.
After the 1979–1981 round of allocations was completed, an XDR allocation was provided to nations
that had joined the IMF. Many of the recipients of this 2009 allocation were developing countries,
which had been planned in 1997.
HOW ARE SDRs ALLOCATED?

Under its Articles of Agreement, the IMF has the ability to give general SDR allocations to participants
in the SDR Department (currently, all IMF members) in proportion to their quotas within the Fund.
Rich countries receive the bulk of SDRs since the quota is based largely on a country's relative
standing in the global economy. Many have criticized the current quota system, including the G24,
which called for a "shift in quota shares from advanced economies to EMDEs [Emerging Markets and
Developing Economies], while protecting the shares of the poorest countries" in its communique to
the IMF and World Bank Annual Meetings in 2021.

Because the IMF essentially creates SDR allocations out of nothing but the commitment of IMF
member nations, a fresh issue of SDRs signifies an increase in the global money supply. Because the
US owns 16.50 percent of the total IMF voting shares, any SDR allocation must be authorized by an
85 percent majority of the overall voting power. This provides the US a veto over SDR issuance.

SDR allocations are extremely rare; the IMF has only done so four times in its history: in 1970-72,
when SDRs were first introduced as a unit of account; in 1979-81; in 2009, to aid in the recovery from
the 2008 financial crisis; and most recently, in 2021, in response to the Covid-19 issue. In 2009,
countries that joined the IMF after 1981 were given a special allocation to make up for the fact that
they had never received an SDR allocation.

The prospective emergence of SDRs as the "primary reserve asset in the international monetary
system," as envisioned by the 1978 revision to the IMF's Articles of Agreement, would have a negative
influence on the US dollar's existing "exorbitant privilege."

INTEREST ON SDRs AND THEIR PAYMENTS

Importantly, SDRs function as both an asset and a liability for countries when they are issued by the
IMF. Countries whose SDR holdings exceed their allocations get interest based on the SDR interest
rate, whereas those who convert their SDRs to hard currencies must pay the same rate of interest.
As a result, the interest paid and received accounts within the SDR department are both zero.

The SDR interest rate comes handy to calculate the interest rate charged to member nations when
they borrow from the IMF, as well as the interest rate paid to members for their remunerated
creditor seats in the IMF. It also refers to the interest paid to members on their personal SDR holdings,
as well as the interest levied on their SDR allotment.

To conclude, the IMF determines a weekly interest rate based on "a weighted average of
representative short-term loan interest rates in the XDR basket currencies' money markets." The IMF
does not charge interest on the SDRs it assigns to a country. Interest is paid to an IMF member nation
that has exchanged or sold any of the SDRs it was assigned, and it is paid to a member country that
has more SDRs than it was assigned.

THE 2021 SDR ALLOCATION

To help low and middle-income economies recover from the effects of Covid-19 pandemic, $650
billion worth of SDRs were allocated by the IMF in 2021, large enough to account for 69% of every
issued SDRs.

From the $650 billion allocated, high income countries (HIC) received $400 billion, middle income
countries (MIC) received 230 billion and low-income countries (LIC) received just $21 billion worth of
SDRs. This was unprecedented as high-income countries were allocated a lion’s share of SDGs
whereas low-income countries, which were some of the most affected economies due to the
pandemic, received just 3% of the total allocated SDRs. Due to this, many groups including the G7
called the IMF to explore options that allowed channeling of SDRs from HICs to MICs and LICs, along
with providing debt-free financing without economic conditionalities that could force countries to
impose austerity.

Some courses of action in how SDRs can be re-channeled include using SDRs to boost the resources
of IMT’s PRGT, which is the special lending facility for low-income countries. It could also be used to
provide initial funding to the work in progress fund from IMT, the Resilience and Sustainability Trust,
which was greenlit by the G7 recently. Another suggestion is to lend SDRs to multilateral
development banks such as the World Bank.

The current SDR allocation could help MICs and LICs recover from the health and financial crises
created by the Covid-19 epidemic, and the IMF can provide a large-scale debt-free funding
mechanism to aid those countries hardest hit by the pandemic.

VIABILITY OF THE SDRs AS AN INTERNATIONAL RESERVE ASSET

The Special Drawing Right (SDR) is an absolute claim on fellow International Monetary Fund (IMF)
members' hard-currency reserves and certain other designated holders. SDRs represent only 2% of
lower-income nation reserves and less than 4% of global reserves, despite the huge IMF allocations
in August-September 2009.

Currently, the SDR system serves primarily as a reserve-pooling structure, allowing global cash to be
re-allocated from nations with excess liquidity to others with more significant requirements.
However, the system does not provide additional liquidity in the form of increased supplies of high-
powered reserve currencies, which may be required in the event of a worldwide crisis. To stabilize
the significance of IMF members' claims on the reserve pool, the SDR's value is tied to a basket of the
four major reserve currencies. On the other hand, the SDR is not a currency that can be purchased
and sold on private exchanges. Because the international liquidity safety net, including IMF resources,
is weak and conditional, many lower-income nations have chosen self-insurance by accumulating
significant international reserves, predominantly in US dollars and euros. However, the resulting
insurance system has several flaws, some of which are country-specific and others systemic. Reserve
holders may earn meager returns on their "privileged" reserve currency reserves at the country level.
Official changes between reserve currencies could destabilize exchange markets at the system level.
And there are other probable problems.

If countries own more SDRs and fewer reserve currencies, these issues may be reduced. The most
common idea for replacing currency reserves with SDRs on a wide scale is to use a substitution
account, in which countries deposit currency reserves with the IMF in exchange for SDRs. On the
other hand, this strategy shifts the financial burden to the IMF, which would earn low returns on its
currency reserves and be exposed to exchange rate fluctuations. What is the best way for IMF
members to split the bill? Plans for a substitute account fizzled out in 1979-1980, and the problem
has only grown in size since then. The absence of centralized fiscal power, as in the eurozone, limps
the supply of public goods that could improve systemic stability.

If SDRs can only be created through the allocation process and not through replacement, the degree
to which they can substitute currency reserves is self-limiting under current arrangements. In other
words, SDRs have no further worth once the value of outstanding SDR claims is sufficient to acquire
the outstanding stock of gross currency reserves because they are essentially claims on hard-currency
reserves and cannot be utilized in private markets.

If SDR claims could be delivered directly to central banks in exchange for their currencies, as some
have suggested, the situation would be different since the external supply of reserve currencies
would become more elastic in a crisis. This system would have the same stabilizing features as the
central bank swap facilities network established during the previous global financial crisis. Still, it
would be predictable rather than ad hoc, and all countries, not just a chosen few, would have access.
A similar structure may be established without using the SDR simply by establishing lines of credit
from central banks and administering them through the IMF. The IMF could extend the credit directly
to national central banks that meet specific supervisory diligence and political independence
requirements. These credit lines would be in addition to the IMF's enlarged flexible sovereign lending
capabilities. Similarly, even the existing SDR-based reserve-pooling arrangements may be achieved
via explicit reserve pooling, potentially in a more flexible and need-based manner. This technique has
the benefit of avoiding the requirement for governments to offset currency risk taken on through
SDR transactions with opposite, potentially costly, forward-market trades. If SDRs become more
critical as a reserve category, their expenses could become enormous.

More global reserves denominated in SDR would impact exchange rate volatility among the major
reserve currencies, especially by reducing potential government demand movements. As a result, if
other nations pegged to the SDR, their effective nominal (and possibly actual) exchange rate volatility
would decrease. Given China's current strategy of aggressive manipulation against the dollar, adding
the yuan to the SDR basket would essentially boost the dollar's weight in the basket. The logic for
tying the SDR's value to the yuan at this time is unclear, given that the yuan is not an international
reserve currency. An improved global financial safety net, whether based on the SDR or some system
of credit lines centered on the IMF, would strengthen the IMF's position, necessitating corresponding
governance reforms. These should try to give emerging and developing countries a stronger voice, in
keeping with their expanding economic clout. A more robust safety net could increase moral hazard
among market participants or governments, necessitating an improvement of the IMF's
macroeconomic and financial surveillance authorities. This shift would aggravate the need for
governance reform.