Toward a More Stable Global Reserve System

Christopher Reim Mariam El Hamiani Khabat Vladimir Olarte Cadavid Deepika Sharma Bill Papadakis Columbia University | School of International and Public Affairs New York (29 December 2010)

As the New World, New Capitalism conference meets for its third time since the beginning of the Global Economic Crisis of 2008, the debate over improved international financial systems has advanced, addressing the systemic risk of high sovereign debt. Persistent unemployment and high levels of public debt in developed countries is juxtaposed with renewed growth and economic vitality in emerging economies, most notably China. This has exposed conflicting policy priorities globally. As Europe makes consolidation its primary goal, the United States (US) is moving ahead with further monetary expansion to solve seemingly intractable unemployment. Asian economies however have managed to avoid immediate effects of the recession and are again accelerating growth. Given this conflict of priorities, the underlying problem of global imbalances only becomes more pronounced, threatening further instability in the years ahead. As we gather to discuss international cooperation in financial markets, we believe that a discussion on the global reserve system is necessary. In our view, historically high foreign reserve holdings represent various points for market failure going forward: added volatility in currency markets from government intervention; continued global imbalances between trade surplus and trade deficit countries; and an expensive self-insurance mechanism especially for developing countries. For the purposes of this paper, we limit our discussion to the global reserve system, only considering international trade at the margin where it touches reserves. We consider the current model an ad hoc reserve regime, and acknowledge that the world is continuing to move toward a multi-currency system, as reflected in the reduction of the US dollar in total reserve holdings. Further, we consider how a central banking asset may be managed to replace sovereign currency, focusing as a viable option on the Special Drawing Rights (SDRs) currently established by the International Monetary Fund (IMF). The Current Reserve System Can be Improved The push for global financial reform has been further accelerated in 2010 with the unfolding of the European debt crisis, as well as with what may become ongoing currency depreciation as a competitive strategy. Using government intervention in the foreign currency markets to help maintain higher than equilibrium exchange rates (depreciating their value), the governments of several emerging economies and developing countries have spent billions in foreign reserve holdings, in an attempt to promote export-led growth. Whether this is a good use of national assets is one question; however we focus our attention on the accumulation and management of those foreign reserves. It has been argued that the dominant position of the United States as the primary reserve-currency issuing country has allowed the US to live beyond its means for an extended period.1 But this policy has also come with significant drawbacks, as it has contributed to instability in the world economy by generating excess monetary growth, domestic asset price bubbles, inflation and

This argument includes the concepts of seignorage revenue from the expanded use of dollars in reserve holdings, the lending spread benefit of exorbitant privilege, and the inequity of US export of monetary policy through international use of the dollar.

overheating.2 Interest rates were kept at artificially low levels for a protracted period and valuable resources in developing economies were being wasted, as many countries chose to accumulate low-interest yielding dollar-denominated reserves instead of investing in needed infrastructure. What has often been argued to be an inevitable collapse of this equilibrium took place through the collapse of the bubble in the US real estate market that started in 2007 and metastasized into the global financial crisis of 2008.3 These events have given rise to a renewed debate on the role of the US dollar as the worlds reserve currency and to a closer examination of its alternatives. Increased trade surpluses in emerging market economies (EMEs), Germany, and Japan have necessitated a commensurate increase in current account deficits in other parts of the world, predominantly by the US. Moreover, continued demand for cheap imports by American consumers has been fundamental for the economic growth in export-based economies around the world. It is this global trade imbalance that perpetuates the current global reserve system, led by the US dollar, but increasingly involving other leading currencies. During the past decade, there has been an unprecedented shift in reserve accumulation pattern especially in terms of size and geographical distribution. Since 2000, worldwide reserve holdings had almost tripled, growing from $1.2 trillion in January 1995 to more than $4.0 trillion in September 2005.4 Reserve accumulation has displayed an unstable profile. Between 1995 and 2001, the financial crises affecting a number of EMEs in a context of increasingly liberalized capital flows, driving reserve holdings as a central bank strategy. Beginning in 1999, the desire for self-insurance gained momentum among reserve accumulators. However, the most spectacular increase was observed since January 2002 - world reserves have risen by 91%. The top three accumulators are China, Japan and Taiwan. The top two holders, Japan and China, accounted for more than half of the world accumulation since 2002; they currently hold around 40% of the total stock of reserves. Oil-exporting countries are also a growing part of total reserve accumulation, fluctuating with oil prices. The problems of the current US dollar-based system have much to do with a historical bias favoring the US, and its reluctance to relinquish the competitive advantages (and burdens) of being the worlds primary reserve currency. While other currencies are available for reserve holdings, the US continues to represent typically more than 60% of the global reserve total, largely as a function of ease of liquidity, general security of US Treasuries, and the highly developed financial markets supporting the US Treasuries market. There are three primary problems that underlie the pressing concern to reform the global reserve system:5 (i) The current system places the burden of adjustment to payment imbalances on deficit nations, which generates global recessionary effects (the Anti-Keynesian bias). These global imbalances are further heightened by the rise of reserve holdings over the past decade. (ii) A reserve-issuing country cannot prudently maintain the value of the reserve currency while also supplying liquidity to the world (the Triffin Dilemma defined by economist Robert Triffin, 1961). Large swings in the value of the dollar since the 1960s were due to cycles of confidence in the US dollar as a reserve currency (and there is a dollar shortage when the US runs a surplus). (iii) There is a growing inequality bias within the current system, caused by lending (through reserve purchases) to the reserve currency countries at low interest rates. This includes pro-cyclical patterns of capital flows to developing countries (referred to as the instability-inequity link by Ocampo, 2009)
2
3

4 5

Asia is Learning the Wrong Lessons from its 1997-98 Financial Crisis, Roubini, N. (1997). How Imbalances Lead to Credit Crunch and Inflation, Financial Times 17 June 2008, Wolf, M. Reserve totals are according to IMF data as of 2005; reserve levels have dropped moderately since 2008. Issues as defined in Building an SDR-Based Global Reserve System, Ocampo, J. (2009), page 1-2

These issues do not of themselves force a collapse of the current practice of US dollar-based reserve accumulation, but they do perpetuate dissatisfaction among EME and developing countries. It may be possible to establish a more stable and equitable reserve system that avoids the inherent policy conflicts of the current system. But to do so will require multilateral agreement, which has eluded policy makers for most of the past century. It is relevant to begin by understanding the true costs of the current model. The High Cost of Reserves as Social Insurance In his address to the IMF on the topic of reserves in 2001, Stanley Fischer expressed the benefit of foreign currency as a means of protection in the capital markets. He argued that holding reserves equal to short-term debt was an appropriate starting point for a country with significant but uncertain access to capital markets. However, countries may need to hold a much larger base of reserves, depending on their macroeconomic fundamentals, their exchange rate regime, the quality of financial sector supervision, and the size and currency composition of the external debt.6 Of specific concern are those countries vulnerable to domestic liability dollarization, in which a significant portion of public debt is denominated in US dollars, and which may become a larger liability if the local currency depreciates against the US dollar. Prior to the rapid growth in capital flows to developing economies beginning in the 1990s, the traditional rule of thumb was that a country should hold reserves equivalent to three or four months worth of imports. However this current account view is now less complete, given the level of capital market openness across developing countries. The ratio of short-term debt to reserves is the best correlated indicator to the incidence of financial crises (which was proposed by then Federal Reserve Bank Chairman Alan Greenspan). The availability of counter-cyclical credit to offset current account shocks should reduce the amount of reserves a country needs. And countries with freely floating exchange rate regimes should by definition not require any. In the absence of improved access to capital in times of crisis, a large base of reserves has become the operating standard. Accumulating reserves comes at a high cost to emerging and developing countries. Central banks primarily hold their foreign exchange reserves mostly in the form of low-yielding short-term U.S. Treasury securities. According to economist Dani Rodrik, holding these assets comes at an opportunity cost that equals the cost of external borrowing for that economy (or alternatively, the social rate of return to investment in that economy). The spread between the yield on liquid reserve assets and the external cost of funds (often several hundred basis points) represents the social cost of self-insurance. Increased reserve holdings are only a part of a combined strategy for protection against sudden stops and financial crises. Countries have been reluctant to rein in short-term external borrowing, which by doing so would also significantly add to overall liquidity and at a lower cost than accumulating reserves. Rodrik states: Developing countries have responded to financial globalization in a highly unbalanced and far from optimal manner. They have over-invested in the costly strategy of reserve accumulation and under-invested in capital-account management policies to reduce their short-term foreign liabilities. 7 The Ad Hoc Formation of the Multi-Currency Reserve System The role of the US dollar as the primary reserve currency follows first from its role in international trade transactions. Importers, exporters and bond underwriters will want to price transactions in the currency related to their trading partners, which for most of the past century was predominantly the US dollar. As the US dollar share of global transactions has fallen from a high of over 50% mid-century to roughly half that now, other currencies have grown in importance as viable reserve currencies. The British Pound, the Euro and the Japanese Yen are each freely floating currencies with stable macroeconomic fundamentals and represent significant blocks of world trade. For most central bankers, their total pool of foreign reserves also includes
6 7

Comments by Stanley Fischer at the IMF/Work Bank International Reserves: Policy Issues Forum, 28 April 2001. The Social Cost of Foreign Exchange Reserves, Rodrik (2006), page 2

some mix of these currencies along with the US dollar. The vast size of the global economy is such that there are deep and highly liquid markets for trading in these currencies and in the government debt securities issued by these countries, though none as large as that of the market for US Treasuries. The Chinese Renminbi (or the Yuan) is a fast-growing currency in international trading, though Chinas role primarily as an exporter continues to favor use of the other major currencies for its transactions. Though the market for the renminbi is robust, because it is pegged to the US dollar effectively invalidates it for now as a reserve currency. If multiple currencies make up the average basket of reserves, the potential for a rebalancing of the mix as a function of currency values will always be present. Despite the view that central bankers, being conservative, are not likely to exchange one reserve currency for another, as suggested by Barry Eichengreen and others, the possibility for heightened trading exists. This view discounts the instability inherent when currency valuations do fluctuate. If a broad depreciation trend is recognized by central bankers, they will take steps to adjust the reserve portfolio, further adding to the size and likely volatility of the currencies involved. Most importantly, a multi-currency reserve system does not address the Triffin Dilemma issues at the heart of the debate. The exorbitant privilege deriving from seignorage to the issuer currency would be shared across more than just one country (and in fact it is today) and the underlying conflict of the domestic bias requirement of fiat money is not eliminated. The underlying weaknesses of the US dollar today made worse by incomplete regulation and conflicts of interest inherent in the financial services sector, coupled with accommodating monetary policies and the rise of fiscal dominance in US policy since the 1980s can just as clearly be matched by perceived weaknesses in other leading reserve currencies. The second largest reserve currency, the Euro, continues to suffer from questions of long-term sustainability despite the commitment of capital in recent weeks to stabilize sovereign debt default risk in its periphery countries. Thus, the concept of the IMFs Special Drawing Rights (SDRs) as a global reserve currency has regained momentum since the crisis in 2008, for several reasons. With the rapid rise of reserve holdings over the last ten years (since the currency crises of the 1990s), emerging markets and developing nations have viewed their reserve holdings as a protection against financial and currency crises (and to avoid having to borrow under conditionality from the IMF). More importantly, these reserves have provided the capital for trade-surplus countries to actively intervene in currency markets to manage the appreciation of their currencies, creating the environment for currency wars of devaluation to establish competitive advantage for export-led growth. The Chinese central bank president Xiaochuan Zhou wrote in 2009 that an international reserve currency should be created that is disconnected from individual nations, that is stable and that can create and control global liquidity (rather than credit-based national currencies). He suggested that SDRs managed by the IMF may be that mechanism, given a settlement system; and he promoted the use of the SDR for international trade and investment transactions, including financial assets denominated in the SDR. As has been expressed by various economists and political leaders, the international financial system can improve if a substantial portion of the demand for holding additional international liquidity (as reserves) were to be met by creation of more SDRs instead of exclusively by expanding foreign currency holdings, as in the recent past. Expanding the Use of SDRs as a Reserve Mechanism The SDR was created by IMF in 1969 to support the fixed exchange rate system of the time. It was created as a central bank asset only, not as a global currency. It was originally conceived in 1960 as a French idea to be backed by gold (which foundation itself was first suggested by John Maynard Keynes in 1944 as Bancor). It has a valuation based on a basket of industrial economy currencies (currently a weighted mix of US dollar, the Euro, the Japanese Yen and the UK Pound) and can be exchanged for freely tradable currencies. It is not a claim on the IMF, but instead is a claim on the currency of an IMF member country. 8 The intention is that
8

For additional information on the structure and role of SDRs, see http://www.imf.org/external/np/exr/facts/sdr.htm.

countries may trade currencies for their SDRs, or where necessary, the IMF would manage liquidity from members with large SDR holdings. One of the main functions of the SDR was to solve the Triffin Dilemma as the international supply of gold and U.S. Dollar was insufficient for supporting the expansion of world trade and financial development. After the collapse of the Bretton Woods System in 1973, the major currencies shifted to a floating exchange rate regime and the need for the SDR vanished with the evolution of international capital markets that facilitated borrowing. Prior to 2009 there were 21.4 billion SDRs in existence, representing less than 0.5% of world total (non-gold) reserves. Originally distributed in proportion to countries IMF quotas on the dates of allocation, SDRs have tended to gravitate from developing countries in deficit toward industrial countries in surplus.9 Following the commitment made by G-20 leaders at their April 2009 summit to increase global liquidity, the Board of Governors of the IMF approved a general allocation of SDRs equivalent to US$250 billion in August 2009. It was employed to provide liquidity to the global economic system by supplementing member countries foreign exchange reserves. About US$100 billion of the general allocation went to emerging markets and developing countries, becoming a key example of a cooperative multilateral response to the global crisis in 2008-10, offering significant support to the Fund's members in this challenging period.10 It is important to underline the difference between a reserve currency and a reserve asset. A reserve currency, such as the US dollar, is a currency largely used in international financial and trade transactions, which needs to be reliable and stable as a store of value. To be considered as a reserve asset, apart from gold, an asset needs generally to satisfy the criteria of security, liquidity and returns. This justifies why the majority of foreign reserves are invested by central banks in US Treasuries. The SDR requires specific delineation to best be understood as a reserve asset rather than as a supranational currency. Keeping in mind only that we discuss the purpose of the SDR for use as a reserve mechanism, we first acknowledge that currency is only issued by a central bank. Considering that SDRs would only be issued by consensus within the IMF, growing demand for reserves would be managed using drivers of equitable and optimal distribution among countries. As the IMF makes clear, the SDR is not a currency, and is structured to be defined as a central bank (not private entity) asset. The diffusion of its use more broadly into the global reserve system is intended to encourage the substitution of SDRs for foreign currencies, reducing reliance upon domestic monetary policies of reserve currencies. Central Banks hold international reserves for four essential reasons: (i) to satisfy the need of international trade transactions (imports) (ii) to satisfy their foreign debt payments; (iii) to sterilize excess liquidity generated from exports; and (iv) to manage exchange rates through central bank interventions. In this context, one of the key features of a reserve asset is to be liquid enough to fulfill balance of payments transactions as needed. However, during the last decade, one of the main drivers of the unprecedented accumulation of official foreign assets was for self-insurance against crisis (a lesson learned from the series of crises that occurred in the 1990s and early 2000s). Foreign reserve accumulation therefore tends to be less correlated a countrys traditional need for foreign reserves. Reform of the international financial system, specifically with regard to correcting the pressure on global imbalances from the accumulation of reserves, requires a reduction in the drivers of demand for reserves (including better availability of counter-cyclical capital in crises) and reform of the assets underlying reserve holdings. According to economist Joseph Stiglitz, a new global reserve system is absolutely essential to restore the global economy to sustained prosperity and stability.11

9 10 11

Understanding Special Drawing Rights, Williamson, J. (June 2009) IMF Press Release, 13 August 2009. Towards a New Global Reserve System, Stiglitz, J. (2009)

Either easy convertibility from SDR to currencies or a system that allows use of SDRs in international transactions is necessary. Likely, such a mechanism may apply first to a clearinghouse function for transactions, in which trades can be settled using the SDR, allowing for a delay in the timing of actual conversion to local currencies. Given this time-variant view, the SDR may provide a backing-asset role to currencies as a reserve mechanism, such that major currencies remain a first-tier source of liquidity for reserves, the SDRs provide a second-tier, nearly as liquid but requiring convertibility, ideally without conditionality. Both currencies and SDRs would comprise the total reserve pool for a country, with the SDRs assuming a measurably longer average holding period, though with effective convertibility to local currency to maintain the liquidity requirement of central bankers. Also, if used as a settlement mechanism for trade surplus or deficit between IMF countries, the SDR might promote added stability that a multi-currency system likely could not offer. IMF-member governments would commit to accepting SDRs in settlements between countries, while the IMF would provide a clearinghouse function of converting SDRs into national currencies (without limit and on demand, market clearing to avoid liquidity or transactional constraints). Using the quota system, the IMF would itself build a reserve of currencies to facilitate an ordering market; and a format for allocating SDRs between surplus and deficit countries can be used to provide greater market debt and stability. Barry Eichengreen disagrees on this point, arguing that a private markets emphasis. He believes that: (a) countries can create their own basket of currencies without using an SDR as the instrument; (b) that countries first would need to peg to the value of the SDR (a topic that requires its own attention, not offered in this paper); and (c) countries would then need to begin to issue SDR-denominated sovereign bonds, and be willing to purchase SDR-denominated bonds in the market. While we agree that his view of the market pressures against an SDR instrument is real, we believe this may represent a dated view to reform. International swap lines used today, including currency swaps, have gained in sophistication since the SDR was first developed in 1969. It is possible to recognize that, gradually, the SDR may constitute a larger percentage of total central bank reserve assets, thus off-loading some portion of the currency issuance provided by the US via its large trade deficit. IMF as the Platform for Reserve Coordination There are three main alternatives in administering a SRD-based global reserve system: (i) creating a new International Clearing Union as suggested by Keynes in 1944, (ii) creating a Global Reserve Bank as inferred from Stiglitz (2009), or (iii) continue to strengthen the IMF as the SRD global clearing house as proposed by Chinas central bank (Zhao 2009). Since the first two options are difficult because of the low likelihood of reaching international political agreement in a new global institution, we consider the IMF to be the institution that is better positioned to manage the SRD-based global reserve system. Not only it is politically feasible at this time, but the institution is suited for the task.12 In fact, the IMF SDR Department has been the channel through which all transactions and operations involving SDRs have been conducted since 1969. The IMF pays interest to each holder of SDRs, and makes charges at the same rate on each participants net cumulative SDR allocation. Under its Articles of Agreement, the IMF may allocate SDRs to members in proportion to their IMF quotas. Such an allocation provides each member with an asset (SDR holdings) and an equivalent liability (SDR allocation). If a members SDR holdings rise above its allocation, it earns interest on the excess; conversely, if it holds fewer SDRs than allocated, it pays interest on the shortfall.13 More generally, the SDR market has functioned purely on a voluntary basis during the last two decades and the IMF facilitates transactions
12

13

Reform of the Global Financial Architecture, Truman and Schinasi, Peterson Institute for International Economics, Working Paper Series, WP 10-14 (2010) Special Drawing Rights Factsheet, IMF website, 2010.

between members seeking to sell and buy SDRs. In the event that there are not enough voluntary buyers of SDRs, the IMF can designate members with strong balance of payments positions to provide freely usable currency in exchange for SDRs. An important point of contention is whether the IMF should issue regular SDR allocations that reflect the additional global demand for reserves and secure an equilibrium long-run monetary growth rate, independent of short-run fluctuations in aggregate demand; or whether it should try to engage in short-run countercyclical fine-tuning.14 We concur with the idea of issuing SDRs in a countercyclical way is the best option to ensure long-term stability of the system.15 Geopolitical Considerations of an SDR Reserve Mechanism China is the largest holder of U.S. Treasury debt and top U.S. creditor. US dollar assets comprise approximately 65% of their reserves, which translates to approximately $ 906.8 billion16. While China claims that a switch to SDRs is imperative to prevent the riskiness of credit-based national reserve currencies from facilitating global imbalances and fostering the spread of crises, their real motivations may actually be less globally-minded. The huge portfolio of dollar-denominated assets (mainly US Treasuries) that China holds could suffer valuation losses from dollar depreciation which might result from the turnaround in recession from recent US actions to stimulate the economy generated and hence, higher inflation. This situation, termed the dollar trap after a similar Sterling trap faced by France in 1920s, is at the heart of Chinas fear of US Inflation and hence, the proposal for SDRs. Countries that are faced with expanding dollar portfolios can usually allow their currencies to appreciate to counter the problem. However, until recently, China has been reluctant to let the Yuan appreciate. China also wants to expand the basket of currencies that form the basis of the SDR valuation, preferably to include the Chinese renminbi. Despite the size of the Chinese economy and the importance of the renminbi in international trade, the IMF has not yet included it as a reserve currency or even hinted on any intentions to do so. The persistent reason given by the IMF is the fact that the renminbi is not a freely traded currency due to its peg to the U.S. Dollar and hence it is not freely usable. Nevertheless, China recently reduced its US dollar peg as it bowed to international pressure and its own domestic concerns. Hence, the IMF seems to be on the path of including the renminbi in its calculations contingent on whether it is allowed to float more freely against the other major currencies. The US and UK are currently opposed to SDRs as replacement to the US dollar as the new global reserve currency. They prefer to delay and postpone the discussions, and to maintain the status quo for as long as possible to support their primacy in the financial markets. Given that a SDR-denominated instrument would not be comprised entirely of dollars, the net effect would become a larger overall debt liability to the US. The use of a substitution account (US dollars for SDRs) had been proposed, however the US was reluctant to accept an SDR-denominated security (and thus risk of floating valuation on a portion of US public liabilities, and the end of US exorbitant privilege). Due to the European Monetary Systems exchange rate mechanism (ERM II) convergence criteria, the Euro is the primary currency for determining the basis to set values of various currencies in Europe. The Euro currency accounts for 26% of SDR valuation (under the current formula) and the various countries in the Eurozone hold about 28.5% of total SDR reserves.17 However, the European Central Bank (ECB) also seems unimpressed by the idea of SDRs. A recent release by ECB Vice President Vitor Constancio emphasizes that there is no medium-term alternative to the dollar for the international monetary
14 15 16 17

The Case for Regular SDR Issues, Williamson, J. 2009 For related commentary on the role of the IMF and SDRs, see writings by Camdessus (2000) and Ocampo (2002). US Treasury Data on Reserve Holdings (October 2010) IMF valuation for SDRs is revised annually; data for SDR holdings per SDR Factsheet, IMF website, 2010.

system and the idea of using the IMFs theoretical currency, the Special Drawing Right (SDR), in place of the dollar is a non-runner.18 Moreover, a transition which reduces the use of US dollars for reserves would need to address the potential for devaluation or destabilization of the US dollar. Conclusion As we toward the economic challenges in 2011, the divergent paths of the US, Europe and the EMEs form a troubling environment more likely to add to instability rather than to reduce it. The goal of multilateral cooperation must again be to balance such conflicting interests, and in our view that must begin with matters of global imbalances. The continuation of the US dollars dominant position as the primary reserve-currency represents a conflict of interest between US monetary policy and financial stability for those nations pegged to the dollar or holding significant dollar-denominated reserve assets. Continued expansionary policy has the potential to generate domestic asset price bubbles, inflation and continued wealth transfers from trade surplus countries to the US. Acting as a counterweight to consolidation efforts in the Eurozone, the net effect is more likely to prolong weak growth and unemployment. Countries have over-invested in the costly strategy of reserve accumulation to protect themselves against financial and currency crises, but holding reserves comes at the opportunity cost of external borrowing and the social rate of return to investment. A better alternative would be to invest more in capital account management policies. An SDR-based reserve system could coordinate global effort in this direction. Again we reiterate that we propose the use of SDRs as a reserve mechanism, not as a global currency. The development of a SDR-based global reserve system has the potential to reduce countries reliance in domestic monetary policies of reserve currencies and reduce the cost of opportunity of holding reserves. SDRs can assume a measurably longer average holding period with effective convertibility to local currency to maintain the liquidity requirement of central bankers. Once established as a meaningful component of a total pool of reserve assets including a reduced proportion in domestic currencies, SDRs could be provide an innovative solution for countries facing sudden stops during a financial crisis. For these countries, SDRs could provide the asset base to secure affordable (and nonconditional) access the resources to stimulate the economy, increase investment, or pursue developmentrelated spending. Currently, the IMF allocates SDRs through a general allocation according to countries quotas such that the richest G-8 countries (which already enjoy reliable sources of financing in times of need) obtain more than 45% of the available SDRs. To provide SDRs as a financing option for developing countries facing crisis, special allocations could be made which would require amendment to the IMFs Articles of Agreement.19 Use of SDRs primarily as central banking reserve assets would make this market-stabilizing financing mechanism more realizable, ideally reducing future volatility during crises. SDRs have previously been proposed as an aid and development tool for low-income countries, based on the concept that SDRs should facilitate movement of real resources from developed to developing countries (or as we propose herein, between trade surplus and trade deficit countries). This may in time form a viable development-oriented aid financing tool for low-income countries, or could provide a way of financing commodity stabilization schemes since many of the balance-of-payments problems that low-income countries (which are often trade deficit countries) encounter as a result of the instability of their export receipts.20

18 19 20

Reuters press release (dated 7 Dec. 2010) The precedent is the allocation of SDRs in 1997 when new members were provided special allocation of SDRs. The Benefits of Special Drawing Rights for Least Developed Countries, by Graham Bird, World Development, Volume 7, pages 281-290

The increasing pressures of the conflict of interest as first defined by Robert Triffin in 1961 only make the current reserve system all the more unsustainable. The US must find a way to reduce its global trade imbalance; continuing to benefit from the advantage of seignorage only serves to postpone the inevitable. SDRs are a useful mechanism along the way to reducing that imbalance. Nevertheless, there will be political challenges to adopting this concept, given the current opposition by the US and UK, and the IMFs governance structure, with significant weighting to the US and control across the G-8 countries. If used as a settlement mechanism for trade surplus or deficit between IMF countries, the SDR can promote added stability that a multi-currency system likely could not offer. Furthermore, the IMF is a feasible and suitable institution to manage an SDR-based reserve system and advance global financial stability. The real challenge is now more political than technical.

REFERENCES: Managing a Multiple Reserve Currency World, by Barry Eichengreen, University of California Berkeley, from The Future Global Reserve System An Asian Perspective, Asian Development Bank paper (June 2010) Understanding Special Drawing Rights, John Williamson, The Peterson Institute for International Economics Number BP09-11 (June 2009) The Social Cost of Foreign Exchange Reserves, by Dani Rodrik, International Economic Journal, vol. 20, no. 3 (September 2006), Report of the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System, United Nations (September 21, 2009), available at http://www.un.org/ga/econcrisissummit/docs/FinalReport_CoE.pdf The build-up of reserves contributes to global imbalances and insufficient global aggregate demand, as countries put aside hundreds of billions of dollars as a precaution against global volatility. Not surprisingly, America, which benefits by getting trillions of dollars of loans from developing countriesnow at almost no interestwas not enthusiastic about the discussion. The dollar reserve system is fraying; the question is only whether we move from the current system to an alternative in a haphazard way, or in a more careful and structured way. Those with large amounts of reserves know that holding dollars is a bad deal: no or low return and a high risk of inflation or currency depreciation, either of which would diminish their holdings real value. (Stiglitz, UN Commission Report 2009). The Instability and Inequities of the Global Reserve System by Jos Antonio Ocampo, DESA Working Paper No. 59, ST/ESA/2007/DWP/59, (November 2007) Building an SDR-Based Global Reserve System, Journal of Globalization and Development, Issue 2, Jose Ocampo, 2009 Gold and the Dollar Crisis: The Future of Convertibility, Robert Triffin, Yale University Press (1960) Treatise on Money, John Maynard Keynes, Harcourt, Brace, and Company (1930) The Benefits of Special Drawing Rights for Least Developed Countries by Graham Bird, World Development Vol. 7, pp 281-290 Reform of the Global Financial Architecture, by Truman and Schinasi, Peterson Institute for International Economics, Working Paper Series, WP 10-14 (2010) The Case for Regular SDR Issues: Fixing Inconsistency in Balance-of-Payments Targets, by Williamson, J., Peterson Institute for International Economics, as published on VoxEU.org (2009)

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