ECONOMICS, FREE POM
ANALYSIS OF RECENT IMF REPORT ON SDR ADJUSTMENTS (FREEPOM)
AUGUST 5, 2015 By JC Collins
NOTE: Authorization is given to re-post this material so it reaches the widest possible audience. Please just link back to the POM site and give credit for the work. There is much confusion and misleading information being presented regarding the changes to the monetary framework. The more this process is understood the more people can prepare and financially plan.
With yesterday’s announcement from the IMF that a recommendation has been made to delay the effective date of the new SDR basket, which would include the Chinese renminbi, by 9 months, it becomes important that we take this opportunity to review the facts which have been presented here on POM over the last 19 months, and bring a sense of understanding to the issue.
The first thing to extract from the IMF statement yesterday is that the recommendation was not to exclude the RMB, but only delay the effective start date of the new basket. Sites, such as Zero Hedge, have been quick to put out articles with titles stating that the IMF has delayed the addition of the RMB.
This is misleading as the recommendation was based on the effective date of the new basket, as opposed to the vote on including the Chinese currency.
The reason for delaying by 9 months was given as follows:
“SDR users and members have indicated that January 1 is not ideal for the inception of a new basket. Most markets are closed on January 1st and trading is relatively thin in the days before and after the New Year. This complicates portfolio rebalancing operations necessary to adjust to the new baskets weights every five years.”
Sounds reasonable and logical from a functional perspective. The statement continues:
“The possibility of a new currency included in the basket has also generated a higher-than-usual level of uncertainty for SDR users. Moreover, SDR users have underlined that should a new currency be added to the SDR basket, more lead time than usual would be required to adjust to the new composition. Many have indicated that a lead time of six to nine months would be desirable in such a case.”
Without specifying which “SDR users” have expressed this “higher-than-usual level of uncertainty” the statement goes on to suggest a “lead time” of six to nine months before the new basket composition becomes effective.
The SDR composition on December 30, 1998 included, along with the dollar, yen, and pound, the Deutsche mark and French franc. On January 4, 1999, five days later, the mark and franc were replaced with two separate valuations of the euro, based on each of the previous currencies from Germany and France.
This basket composition remained in effect for only two years instead of the usual five, when on January 2, 2001, one day after New Year’s, the composition changed again, when both valuations of the euro (the mark and franc valuations) were merged into a single valuation.
One can research all previous adjustments to SDR basket compositions and realize that they always take place within a few days of the New Year, whether currencies were added, subtracted, or merged together in one valuation.
So why the concern over the timeline of adding the Chinese yuan?
The statement continues:
“In light of these issues, staff proposes to extend the current basket until September 30, 2016. The extension would not in any way prejudge the outcome of the review or whether the RMB should be included in the basket.
Rather, it would address concerns expressed previously by SDR users about introducing a new basket on the first trading date of the New Year.
Early guidance on the current basket’s duration would also help reduce uncertainty for SDR users and facilitate continued smooth SDR-related operations, while also allowing adequate time to make necessary changes to any contractual agreements, including to the PRGT and the Fund’s invested resources.
If Directors agree with the proposed extension, a separate decision would be circulated after the informal Board meeting for lapse-of-time approval.”
It is made very clear in this portion of the statement that the delay is not a function of deciding whether the renminbi should be added, but rather on the timing of the implementation of the new basket after the renminbi has been added.
The inclusion of the RMB has not been delayed as some article titles have suggested. It is likely to proceed as planned on the voting component.
In fact, in order for the “allowing of adequate time to make necessary changes to any contractual agreements” to be effective, it will have to be made clear by early January that the RMB will be added to the SDR. This will give the required nine months as suggested by the recommendation report.
The reference again to “SDR user” concern about introducing a new basket composition on the first trading day after the New Year is somewhat muted when contrasted against the history of SDR adjustments taking place always on the first trading day after the New Year.
The “continued smooth SDR operations” do not specify in detail the reasons why a delay would benefit those operations. It does mention giving adequate time to make necessary changes to any contractual agreements, which would include the PRGT.
For those who don’t know, the PRGT is the Poverty Reduction and Growth Trust program which was established in 2009. The program was designed to lend to members a total of SDR 700 million, which would come from the profits of gold sales. The amounts would be distributed based on the member’s quota amounts.
The idea was that members would use the PRGT funds to subsidize additional lending to low-income countries.
From the IMF:
“As of April 15, 2015, 143 countries representing 94.25 percent of the proposed distribution had pledged to use their portion of the distribution to subsidize lending to low-income countries, which may currently borrow at zero interest from the Poverty Reduction and Growth Trust (PRGT), the IMF’s concessional lending vehicle.”
This area is loaded with research potential when we consider the large amount of gold imports into China, the announcement of lower-than-expected gold reserves by the Chinese last month, and the building momentum to have the RMB added into the SDR.
I have previously stated that China could be planning to place a large amount of gold on deposit with the IMF for a new allocation of SDR, and to subsidize, or underwrite, the exchange of USD held in its foreign reserve account with SDR. This exchange would take place through a substitution account, and was thoroughly covered in the post Will China Transfer American Debt to the IMF.
The diversification of foreign reserves, or the reduction of USD in foreign reserve accounts, is an important step in the multilateral transition which is taking place. The balance of payments deficits can only be corrected by unwinding dollar accumulation and replacing those reserves with an alternative supra-sovereign reserve asset, such as the SDR.
Reserve currency diversification has in fact been taking place since the onset of the euro in early 2001. This diversification has been increasing and will continue to increase proportionately when the Chinese renminbi is included in the SDR basket composition and given official reserve status. The diversification at this point will become more advanced and disruptive to USD interests.
This likely has a lot to do with the pressure American interests are placing on the IMF to delay the implementation, or effective date, of the new SDR basket until September of 2016.
This would give the US another year to fund its deficits and avoid the harsh reductions in entitlements and exchange rate which will be required. This unfortunately puts macroeconomic pressures on every other country in the world.
The only way to avoid such disruptive outcomes is to shift away from using the USD as the primary reserve asset used in global trade. The USD held in the foreign exchange accounts of countries around the world can be deposited in the substitution account with the International Monetary Fund in exchange for claims denominated in SDR.
One of the obstacles for the use of substitution accounts is that the United States would be responsible for maintaining the value of the SDR denominated claims which were exchanged for USD which now sits in the substitution account.
The need for the USD to depreciate has been thoroughly covered in previous articles on this site. The main benefits for a depreciating dollar are realized by increasing American exports, which will lower the debt-to-GDP ratio, and increase domestic production and jobs.
The problem which presents the greatest challenge, and refusal of the US to agree with large reforms to the international monetary framework, are directly tied to its reluctance to carry the costs associated with a depreciating dollar and the lost which will take place in the substitution account.
China, the largest holder of USD denominated assets, is unable to diversify without causing a depreciation of those assets. It has been suggested by China that a substitution account be used to facilitate the diversification of its reserve account while maintaining the value of the assets held in that account.
This predominately helps China diversify its foreign reserve holdings but leaves the IMF exposed to the costs associated with a depreciation of those USD denominated assets.
Continuing to use China as our example, even though all countries holding USD will use the substitution account, when the PBoC exchanges its dollar denominated reserves for a new allocation of SDR, China will in fact become long SDR.
As such, the IMF will be short SDR and long USD. Which means the substitution account’s solvency is at risk when the dollar depreciates.
It is possible that contractual agreements can be arranged to separate the external USD held in reserve accounts, and subsequently in substitution accounts, from the internal domestic dollar, but I have yet to see any evidence to support such a process.
Though my initial analysis figured such a separation, the depreciation of a domestic USD while the valuation of the international USD remained locked within a substitution account, seems to be less likely considering the level of resistance which the United States is orchestrating against monetary reform.
So who should compensate the IMF for these portfolio losses?
Most, including China, feel the United States should cover the losses in the substitution accounts when the dollar finally depreciates. Unfortunately, the US refuses to carry this risk and certain loss; which tells us something, and provides confirmation, about the future trend of the dollar.
The need for a supra-sovereign multilateral fiscal authority at the global level becomes apparent when we fully understand the need to underwrite the SDR substitution account.
Some sort of contractual agreement has to be in place to ensure that losses on exchanged USD reserves are distributed amongst members based on quota amounts and reserve substitutions.
Previously the IMF and the emerging economies, such as China and India, have been unwilling to use gold reserves, or holdings, to support the substitution accounts.
Based on the transfer of gold which has taken place between the West and China, there is a growing probability that gold will in fact be used to subsidize and underwrite the substitution of USD denominated reserves with SDR.
Perhaps we will see a percentage of gold placed on deposit with the IMF from China, while another percentage is deposited within the accounts of the Asian Infrastructure Investment Bank (AIIB) and BRICS New Development Bank, so both new multilateral institutions can act as underwriters for the substitution accounts.
The transfer of gold to China could be one possible way in which the US has indirectly underwritten the substitution account, without taking on the full accountability of dollar depreciation worldwide when it finally occurs.
Consider that it was the traditional list of American allies which quickly signed up as founding members of the China lead AIIB. All of these countries have a large percentage of their foreign reserves denominated in USD.
With the American refusal to implement, or pass, any legislation supporting the reform of the international monetary system, it is being forced upon other countries and institutions to make alternative plans and implement strategies which can diversify foreign reserves and build towards a new multilateral exchange regime which will work towards balancing the balance of payments and correcting other inherent deficits and deficiencies.
Transferring the financial liability of depreciating dollar reserves to the IMF will mean the Fund has to manage low returns on those assets, as well as deal with exchange rate changes.
The fact that there was no agreement on risk sharing back during the negotiations which took place throughout the years 1979 and 1980, only enforces the need for a centralized fiscal power to ensure financial stability.
The USD cannot continue as the primary reserve currency based on the deficiencies as defined in the Triffin Paradox. The rise of any domestic currency, such as the Chinese renminbi, to act as a replacement to the USD, will only continue, and possible extrapolate those deficiencies. The world needs a supra-sovereign multilateral asset like the SDR in order to avoid further systemic imbalances.
Currently SDR can only be created through allocation and not substitution. After the financial crisis a new allocation of SDR was agreed upon by all member countries. But this is only a temporary solution and response to the deflationary crisis which began in 2008.
It is important to remember that this crisis is in fact a USD crisis, and can only be corrected by exchanging USD denominated reserves through the substitution account.
Any additional allocations of SDR can be supported by IMF member quota increases. New SDR can also be created through substitution, as explained, and this could be considered a down payment on future quota increases.
This is why the substitution account methods will likely be the path which both China and the IMF take in the coming months in response to the continued delays by the US on the 2010 Quota and Governance Reforms.
To think that the 2010 reforms and the delay in implementing the new SDR basket are not connected would be foolish on our part. And I seriously doubt that anyone would even suggest that. Regardless, the US has pushed China and the IMF, along with traditional US allies, together on the path which will unfold in the coming months.
Denominating global reserves in SDR will stabilize exchange rates by reducing demand for other domestic currencies, including the USD. This demand for USD is what allows and accounts for American deficit spending, which will be debated this September, as well as next September.
Next September is the timeframe the IMF report is suggesting to allow for changes to contractual agreements and other planning around the SDR, which will be required to support the addition of the RMB to the SDR basket.
Do not think for one moment that the decision on the RMB and SDR is being delayed. The fact that preparations are being discussed for its addition should be a clear indicator that big changes are coming. – JC
Don’t forget that the new IMF deadline on the 2010 reforms is set for September 15th of this year. Read here.
And dollar depreciation will be coordinated with the processes explained in the post above. Can also be read in more detail here.
Readers may also gain insight and value from reading the following post:
Hume’s Multilateral Adjustment Mechanism