The IMF’s Special Drawing Rights (SDR) basket is a collection of five major international currencies used to determine the value of SDRs, which are international reserve assets created by the IMF to supplement member countries’ foreign exchange reserves. The current SDR basket includes:
- U.S. Dollar (USD)
- Euro (EUR)
- Chinese Renminbi (CNY)
- Japanese Yen (JPY)
- British Pound Sterling (GBP)
The SDR value is calculated daily from fixed currency amounts of these five currencies and their market exchange rates. The rules for the make-up of the SDR basket are based on their five-year export value and that they are “freely usable,” i.e., they are widely used in international transactions and freely available in foreign exchange markets. The SDR basket is updated every five years to maintain its representation of the relative importance of key currencies in the trading and financial system of the world.
What are SDRs?
Special Drawing Rights (SDRs) are an international reserve asset created by the International Monetary Fund (IMF) in 1969. SDRs are not a currency but a claim on freely usable IMF members’ currencies. SDRs are like an IMF unit of account, and a key element in providing world liquidity and economic stability.
Allocation
The SDRs are distributed to IMF member countries by their quota within the IMF based on their respective economic strength. They can either be used for building up reserves, repayment of loans, or exchange for other available ‘free’ currencies.
Uses
Member countries can use SDRs for currency exchange, loan repayment, or payment of obligations to the IMF. Member countries can also offer or sell SDRs to other member countries.
Interest rates
SDRs are interest-bearing instruments. The interest rate is determined as the weighted average of short-term debt instruments denominated in the currencies making up the SDR basket.
Recent news
The IMF also made its largest SDR allocation of $650 billion in August 2021 to address global liquidity requirements amidst the COVID-19 pandemic. Nevertheless, the equity of these allocations has been brought into question since richer countries are allocated more due to their larger quotas. In spite of this, SDRs are still a useful instrument for helping to foster international financial stability (particularly in times of crisis), by injecting liquidity where it is necessary without saddling the recipient nations with further debt.
What are the benefits of holding SDRs?
Holding Special Drawing Rights (SDRs) as part of a country’s foreign exchange reserves offers several benefits:
Supplementing foreign exchange reserves
SDRs provide an alternative reserve asset to reduce the reliance on expensive domestic or foreign borrowing to augment reserves. They enable nations to experience stability and resilience economically during periods of crisis.
Liquidity and flexibility
SDRs are convertible into freely usable currencies, providing liquidity to address external financing needs or balance of payments shortages. Flexibility allows countries to act swiftly to address economic shocks or crises.
Cost-effectiveness
It is less expensive to use SDRs than other borrowed funds. SDRs bear a low rate of interest and are therefore affordable to use when holding reserve requirements.
Exchange rate stability
SDR value is determined based on a basket of the five largest currencies. The diversification gives greater stability than a lone currency such as the US dollar, reducing exchange rate valuation risks for central banks.
Boosting confidence
Holding SDRs provides countries with “insurance” against external financial risks, enabling them to adopt bolder economic policies without fear of depleting reserves. This can support recovery efforts during global or regional crises.
Promoting global economic stability
By supplementing global liquidity, SDR allocations help stabilise vulnerable economies, minimize economic spillovers, and enhance the stability of the international monetary system as a whole.
What are the potential disadvantages of holding SDRs?
Holding Special Drawing Rights (SDRs) as part of a country’s foreign exchange reserves comes with several potential risks:
Liquidity challenges
SDRs are not widely traded instruments, and their market is relatively illiquid in comparison to other reserve assets like government bonds or major currencies. This can prove to be difficult for countries to swap SDRs for hard currencies when needed.
Interest rate costs
Even though they are low, countries holding SDRs incur charges based on the SDR interest rate. If a country’s SDR holdings fall below its allocation due to usage, it may face net charges, effectively paying interest to use the SDRs.
Risk of non-repayment
When SDRs are used to lend to other institutions or nations, non-repayment risk exists as reserve assets can be diluted. The risk is most relevant in the case of lending agreements with little repayment guarantees.
Political and legal constraints
The use of SDRs in innovative ways, like hybrid capital proposals, often faces legal and political obstacles. For example, some countries have strict rules preventing SDRs from being used in non-traditional forms of reserve management, limiting their utility.
Costs for donated SDRs
If a country donates its SDRs rather than lending them, it loses them as reserve assets and incurs perpetual annual costs (SDR charges), which can strain its fiscal resources.
Limited usefulness for developed economies
For advanced economies with strong reserve currencies, SDRs make up only a marginal portion of reserves and may not significantly enhance financial stability or liquidity.
Conclusion
In conclusion, the IMF’s SDRs are a significant provider of international liquidity, and offer backing for financial stability – especially for those economies which are confronted by external shock or crisis. The SDR basket, being composed of some of the world’s most significant currencies, supplies diversification and exchange rate steadiness – a useful component of reserve holdings. But their restrictions on liquidity, interest, and political constraints point to the challenges of making SDRs a significant reserve instrument. In spite of these prospective constraints, SDRs are still a vital instrument of international finance, economic stability, and international monetary cooperation.
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Caleb Hinton
Caleb is a writer specialising in financial copy. He has a background in copywriting, banking, digital wallets, and SEO – and enjoys writing in his spare time too, as well as language learning, chess and investing.
