HardAssetsInvestor

Written by Brad Zigler  |

March 04, 2010

A New Reserve Currency?

Details

China and Russia are calling to replace the world's dollar reserves with the SDR. But does such an idea make sense?

• What's behind the proposal?
• How the SDR's currency basket has changed
• Why switching to the SDR won't work

 

A week ago, the head of the International Monetary Fund, Dominique Strauss-Kahn, suggested the global lending organization might be called upon to provide its 186-nation constituency an alternative to the U.S. dollar as a reserve currency.

In response to calls by China and Russia to supplant the greenback with special drawing rights—the IMF's internal accounting unit—Strauss-Kahn said, "That day has not yet come. But I think it is intellectually healthy to explore these kinds of ideas now."

Special drawing rights were devised by the IMF in 1969 to replace gold and silver in large international transactions and to serve as a supplement to central bank reserve positions. Though freely convertible in IMF transactions, SDRs aren't a currency. Instead, they're credits that a nation with a trade deficit can use to settle balance-of-payment debts. Since SDRs are ledger entries, their use eliminates the logistics of shipping bullion back and forth to settle national accounts.

SDRs represent the value of a trade- and reserve-weighted basket of currencies, including the U.S. dollar, the euro, the Japanese yen and the pound sterling. The SDR basket's makeup is determined every five years by the IMF executive board and is due for its next revamp later this year. Currently, the SDR basket is weighted as:

 

• U.S. dollar: 41.1 percent
• Euro: 36.1 percent
• Japanese yen: 13.5 percent
• British pound: 8.9 percent

 

The IMF recently increased the SDR float to 204.1 billion, now worth about $313.2 billion.

This year's reset of SDRs is bound to reflect ongoing shifts in central bank reserves positions. In particular, the IMF executive board will consider rejiggering the SDR to reflect a diminution in the dollar's heft.

 

Behind Global Currency Reserves

 

Global Currency Reserve Allocations

Source: International Monetary Fund

 

The U.S. dollar is the world's most widely held reserve currency, making up just under two-thirds (10-year weighted average: 65.2 percent) of central bank holdings worldwide. The currency's ubiquity, however, has been chipped away with increasing velocity over the past decade. As central banks have sought to diversify their reserve positions, dollar concentrations have declined at an average annual rate of 92 basis points (0.92 percent) since 1999.

The primary beneficiary of world currency realignment has been the euro, which now comprises a quarter (a weighted average of 25.3 percent) of global reserve allocations. Since the euro's introduction in 1999, allocations have grown at a 99 basis point compound annual rate.

At a distant third is the British pound sterling (weighted average: 3.8 percent of allocated reserves), once the world's most heavily banked currency. Sterling allocations, though relatively small, have been growing along with the diversification trend. Central banks' holdings of British currency have grown an average 14 basis points a year.

Commitments to the Japanese yen, however, have taken a downward trajectory. With allocations averaging 3.7 percent, the yen's reserve position has been falling at a 32 basis point annual rate.

One of the "intellectually healthy" notions for diversifying away from the greenback was floated last year by the governor of the People's Bank of China, who argued for enlarging the SDR basket to include more currencies and establishing a settlement system that would make SDRs tradable outside of the IMF's books.

Indeed, the trend among central banks is to hold increasingly large positions in currencies that the IMF currently buckets as "other." To be sure, some central bank holdings (weighted average: 18 basis points) are still maintained in Swiss francs, but that position is shrinking by a basis point a year. The "other" category is growing at virtually the same pace as the British pound allocation and now represents nearly 3 percent of global reserve commitments.