March 25, 2009 / 4:20 PM / 10 years ago

How might the SDR become a super reserve currency?

LONDON (Reuters) - Debate about the U.S. dollar’s status as the world’s main reserve currency has grown after China this week outlined how the International Monetary Fund’s Special Drawing Right (SDR) could take over this role.

A bank employee counts one hundred dollar notes at a bank in Seoul February 26, 2009. REUTERS/Lee Jae-Won/Files

U.S. Treasury Secretary Timothy Geithner said on Wednesday the dollar would remain the world’s reserve currency for a long time but expressed openness to the expanded use of SDRs.

China’s suggestions came before the April 2 meeting of leaders from the Group of 20 developed and developing economies. Russia had already put forward the idea of creating a new reserve currency that would be issued by international financial institutions in proposals to this G20 meeting.

Here are some of the reasons why big emerging economies are proposing an international reserve currency and some of the questions that would need to be addressed if the idea were to gain momentum.

WHY INVENT A NEW INTERNATIONAL RESERVE CURRENCY?

A global financial system that is built on the use of one currency as the pre-eminent reserve currency carries risks, according to critics. These include risks arising from the large swings in global reserves that can be caused by swings in the reserve currency’s exchange rate.

The impact on the monetary base of countries accumulating these reserves can lead to excess global liquidity and bubbles. Critics also say that the benefits which the United States enjoys as the printer of the premier reserve currency also promotes global imbalances.

HOW AN SDR RESERVE CURRENCY MIGHT WORK AND ISSUES TO ADDRESS

- Broadening use of the SDR is seen as a crucial step in the process. This will involve promoting its use in foreign exchange trading, as an invoicing currency and unit of account in international trade, and as a currency in which private international financial transactions, such as loans, bonds and deposits, are denominated.

- Will there be a change in the range of currencies included in the basket that forms the basis for constructing the SDR? There is likely to be a push from big emerging economies to expand the basket to include their currencies -- China has already suggested this. The basket composition of the SDR is reviewed every five years and the next review by the IMF's Executive Board will take place in late 2010, according to the IMF ( here )

- Can the IMF introduce SDR-denominated securities by issuing SDR-denominated bonds and if so will it be in sufficient quantity to take account of the liquidity concerns of national reserve managers and investors? If not, will it be more a case of reserve managers synthetically replicating the composition of the SDR by holding appropriate proportions of reserves in the currencies/the debt denominated in the underlying currencies?

- Who decides on the size of issuance of any SDR-denominated bonds? Any debate on this issue will be closely related to reform of IMF governance since the current structure effectively gives the United States a veto.

KEY HURDLES AND POTENTIAL STICKING POINTS

- U.S. resistance to an idea that would remove benefits that accrue to the issuer of the world’s main reserve currency. President Barack Obama on March 24 dismissed suggestions of a move away from the use of the dollar as the world’s main reserve currency. “I don’t believe that there’s a need for a global currency,” he told a news conference. Treasury Secretary Geithner said on Wednesday the dollar would remain the world’s main reserve currency for a long time but expressed openness to proposals to expand the use of the SDR.

- Will China and other big emerging economies whose currencies might be included in an expanded SDR basket be willing to accept the responsibilities that would accompany any move to using the SDR as an international reserve currency, eg by moving to a more flexible currency regime as a quid pro quo?

- How would the transition to a new international reserve currency be managed — any such move is seen triggering destabilising financial flows, eg by pushing up yields on U.S. debt and weakening the dollar — and at what point in the economic cycle would it be possible for the global economy to absorb any such shock? Financial crisis and recession offer far from an ideal backdrop but will the political impetus for any such project ebb in good times?

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