Epoch Times has correctly predicted the IMF would include China in the basket for its international reserve currency. Now that the procedure is over, it’s time to have a look into what this basket is, how it works, and whether anybody actually uses it.
First off, the basket is called Special Drawing Right (SDR). It is the IMF’s money and unit of account. The IMF prepares its financial statements in units of SDRs.
As of Dec. 1, we know it’s made up of the U.S. dollar (41.73 percent weight), the euro (30.93 percent), the pound sterling (8.09 percent), the Japanese yen (8.33 percent), and finally the Chinese renminbi (10.92 percent weight). Although, the renminbi will only be effectively included Oct. 1, 2016.
Nothing in It
Here is the most important misunderstanding: Many people believe the SDR actually contains these currencies, just like a real basket has eggs in it. The SDR basket doesn’t have any notes or coins in it.
Although the IMF created 204.1 billion SDRs (worth around $285 billion) and allocated it to its member countries, the money behind the SDRs actually doesn’t exist—hence the name Special Drawing Right.
By holding one SDR, a member has the “right” to “draw” upon the IMF to be paid the equivalent value in one or all of the currencies that make up the basket.
Ok, there is one use of it. If you are Greece and owe the IMF a lot of money, you could pay the IMF in SDRs.
This is different from holding dollars, for example, because dollars can actually be used to pay debt, taxes, or buy nice things. The IMF also uses SDRs for transactions with members.
Also, the IMF itself doesn’t pay up for the SDRs. It can designate one of the five countries to pay up and accept the SDR in exchange for cash.
Now why is this “special.” Here is the official version from the IMF:
“The United States, concerned that such a unit would compete with the dollar, preferred to build on the existing automatic drawing rights (the gold tranche) in the IMF. [There was] a plan to create ‘reserve drawing rights’ in the IMF. Some European countries feared this mechanism could be interpreted as a replacement for gold and suggested instead the creation of ‘special’ drawing rights.”
The SDR is certainly special because it is so far removed from any real use of money that it is not normal.
Also the SDR has value only because the IMF says so and can force its members to exchange it for real currency.
This is similar to other fiat currencies, like the U.S. dollar. It only has value because the government says so, but at least you can pay your taxes, debt, and other things with it.
The IMF can also just print up SDRs and give them to members, again very similar to the fiat money creation process, with the very important difference that SDRs don’t show up as a liability on the IMF’s balance sheet.
Theoretically, the SDRs could also be used to settle scores between member countries, but that rarely happens because the amount available is so small.
There are only $285 billion worth of SDRs around, but central banks and governments around the world hold around $11.5 trillion in exchange reserves.
So far so good. The SDRs are the IMF’s fiat money, do not actually represent real money, and have very little use in the real world.
Now, how does the IMF arrive at calculating the value of one SDR?
Here is gets even more complicated.
First, it has to determine which currencies to include in the basket and what weight to give them.
To make a complicated story short: The countries that have the highest exports, make up the largest holdings of other central banks’ foreign exchange reserves, and have the highest share of foreign exchange trading, international bank liabilities, as well as debt securities.
All these factors are blended together and result in percentage weights named above.
To understand how the IMF actually calculates the value of the SDR, it is best to start from the end product. As of Dec. 3, 2015, one SDR is worth $1.37.
This is the sum of the cross-exchange rates of the different currencies in the basket (euro vs. U.S. dollar for example at 1.05) multiplied by a so-called currency amount.
The currency amount itself is calculated once every five years after the IMF reviews the weightings of the basket.
It is the product of the percentage weights and the average exchange rate of the individual currency versus the SDR over the 90 days prior to the calculation of the currency amounts.
On Jan. 1, 2011, the last time new weights came into effect, it was the average exchange rate from December, November, and October of 2010 multiplied by the new weight of 41.9 percent. The result: 0.66 for the dollar.
Think about it like this: The dollar contributes 41.9 percent to the total value of the SDR. So the currency amount is the absolute contribution of the dollar as expressed in dollars. In other words, the dollar contributes 66 cents to the SDR’s value expressed in dollars.
The contribution of the euro expressed in euros is 0.42 euro cents and so forth.
To get the SDR value in U.S. dollars, you then adjust each currency’s absolute contribution (0.423 for the euro) with the exchange rate of the U.S. dollar (1.05) and sum up the components.
To reflect international exchange rate movements, it is actually the currency amounts that are fixed for five years until the next review by the IMF, not the percentage weights.
The percentage weights rise and fall with the exchange rate value of the currency compared to other currencies in the basket. So if the dollar appreciates against the euro and the yen, its weight should increase and the other two’s weight should fall.
There is only one problem with the calculation. It’s profoundly circular. In order to arrive at the exchange rate of the SDR in dollars, you have to use the average exchange rate of the SDR against the dollar. This is okay if you already have three month’s worth of past rates, but the IMF didn’t have this in 1969, when the SDR was first created.
But back then, the dollar was backed by gold at $35 an ounce or $1 for 0.89 grams of fine gold. So one SDR was worth one dollar.
When the gold standard collapsed in 1973, the IMF redefined the SDR as a basket of currencies and has evolved its methodology ever since.
Why Does It Exist?
So why does the SDR exist? The IMF says it created it in 1969 to promote world trade.
“The international supply of two key reserve assets—gold and the U.S. dollar—proved inadequate for supporting the expansion of world trade and financial flows that was taking place. Therefore, the international community decided to create a new international reserve asset under the auspices of the IMF.”
This explanation doesn’t make a whole lot of sense, though, because the majority of the SDRs in circulation (182.6 million) were created in 2009, not in 1969.
Maybe the IMF knew about the Chinese central bank governor Zhou Xiaochuan’s plans before he himself knew about it. He wrote in 2009 that the SDR should become the next world reserve currency.