Special Drawing Rights (SDRs): Features, Valuation, Working and Criticisms

In this article we will discuss about:- 1. Meaning of Special Drawing Rights (SDRs) 2. Features of SDRs 3. Valuation 4. Working 5. Merits 6. Present Position 7. Criticisms.

Meaning of Special Drawing Rights (SDRs):

The establishment of the scheme of Special Drawing Rights (SDRs) is a significant attempt of the International Monetary Fund (IMF) cu reform the international monetary system and to solve the problem of international liquidity. After the World War II, the gold standard was replaced by the currency standard.

But, the continued use of the pound sterling and the U.S. dollar as the key reserve currencies proved unsatisfactory because of the deficits in the balance of payments of the U.S. and the U.K.

There was a serious problem of the international liquidity, i.e., the inadequate growth of monetary reserves. In such conditions, the need arose for a new reserve asset. The introduction of SDR as a new international reserve asset by the IMF is a welcome step in the right direction.

The scheme for creating Special drawing Rights (SDRs) was outlined at Annual Meeting of the IMF in October 1967 at Rio de Janeiro (Brazil). The detailed proposals of the scheme were approved by the Board of Governors in April 1968 and the Special Drawing Account came into being on August 6, 1969.

The basic idea behind the SDR scheme was to establish a new reserve asset whose quantity could be consciously adjusted in response to the world’s need for international reserves. The objective of creation of the SDR was to assure an adequate, but not excessive, growth of monetary reserves.

Under this scheme, the IMF has the power to grant SDRs to member nations on a specified basis. Allocation of SDRs is made annually by the collective decision of the participating countries on the basis of their quotas. Possession of SDRs entities a country to obtain a defined equivalent of currency from other participating countries.

The IMF can create new SDRs from time to time in response to the need for additional international reserves. The newly created SDRs are allocated among member nations in proportion to their IMF quotas. When a member’s SDR balance falls below its total allocation, it must pay interest to the IMF on the difference.

Similarly, the members are paid interest by the IMF on SDR holdings in excess of allocations. Thus, by creating SDRs, the IMF aims at increasing the availability of resources to the member countries without putting additional strain on its own resources.

Features of SDRs:

The following are the salient features of SDRs:

1. Additional Reserve Asset:

The SDRs scheme provides a new international asset, in addition to the traditional assets, i.e., gold, key currencies. Now, the member countries of the IMF can hold and use SDRs along with gold and key currencies as international reserves.

2. Cheque-Book Currency:

In the physical sense, SDRs are a cheque-book currency and are created with the strokes of pen. They are simply book keeping entries at the IMF in accounts for the member countries and the Fund itself. They are just like coupons which can be exchanged for currencies needed by the holder of SDRs for making international payments.

3. Transferable Asset:

SDRs are transferable assets. The member countries are required to provide their currencies in exchange for SDRs. A country can acquire convertible currency from the designated country in exchange for SDRs. Designated country is that which has strong balance of payments or large reserves.

4. Backing of SDRs:

SDRs are a liability of the IMF and asset of the holders. There is no backing for SDRs in the form of an asset like key currency. The real backing is the undertaking given by the member countries to abide by the SDR regulations. The country which agrees to the creation of SDRs is obliged to permit drawl and other countries are obliged to accept them as unit of adjustment.

5. Basis of SDRs:

The creation of SDRs is based on the fundamental principle of credit creation in the banking system. The SDR scheme is an extension of this principle to the international level. The IMF can create new SDRs without any increase in deposits of gold or currency by the participating countries. Thus, issue of SDRs means an increase in world’s monetary reserves.

6. Allocation of SDRs:

The SDRs are allocated to the member countries in proportion to their quotas in the IMF. The lion’s share goes to the developed countries and the developing countries get only about a quarter.

7. Special Drawing Account:

Under the changed rules, the IMF maintains two separate accounts:

(a) General Account:

It deals with the general transactions of the IMF relating to quotas, subscriptions, ordinary drawings, etc.

(b) Special Drawing Account:

It deals with SDR transactions. The SDRs are created as a percentage of existing resources (quotas).

8. Paper Gold:

Initially the scheme envisaged that the SDRs would be a sort of paper gold. Their value was fixed in terms of gold. But, since 1974, the SDR has been valued on the basis of a currency basket.

9. Fiduciary Reserve System:

The SDR scheme proposes a purely fiduciary reserve system. SDRs are regularly created by the IMF, accepted by the member countries as paper gold reserves and used for the settlement of international payments.

10. Interest-Bearing Asset:

SDRs are an interest-bearing asset The IMF pays interest to the countries holding SDRs and charge interest from the countries using SDRs.

11. Use of SDRs:

Under the SDR scheme, the participating countries will use SDRs to meet their balance of payments requirements or to improve their adverse reserve position. SDRs are not to be used for exchange with other currencies to reinforce foreign exchange reserves.

12. Limited Use of SDRs:

Ordinarily, a country can use SDRs up to 70% of the allotted authorisation during a given five years. The remaining 30% is to be held for emergencies. Thus, a restraint has been put on the member countries so that they do not rush into using SDRs without drawing upon their other forms of resources.

13. Units of Account:

Use of SDRs as a unit of account has also started. Some countries have pegged their currencies to SDRs. OPEC countries, and some airlines, monetary organizations and banks are using SDRs as unit of account.

Valuation of SDRs:

The original SDR scheme envisaged that SDRs would be a sort of paper gold. The value of SDR was fixed in terms of gold. Initially, the unit value of SDR was determined equal to 0.88867 grams of fine gold or equal to one U.S. dollar.

Later on, in 1974, due to general floating of exchange rates, the standard basket technique was adopted and the value of SDR was fixed in terms of a basket of 16 major currencies. Since 1981, the standard basket is composed of the currencies of world’s five largest exporting countries. The list of currencies in the basket and their weights are revised at the end of every five years.

The currencies and their share in the total weight for 1986-90 are- U.S. dollar (42%); Deutsche Mark (19%); Japanese Yen (15%); French Franc (12%); and Pound sterling (12%). The value of SDR is calculated daily on the basis of market exchange rates. For 1989- 90, the average annual value of SDR was: SDR 1 = Rs. 19.262 or $ 0.75. In 1997-98, it moved to: SDRI = Rs. 50.076 or $ 1.364.

Working of SDRs:

Whenever the IMF finds that there is a need to increase international liquidity, the SDRs are created and allocated to the members in proportion to their quotas. The first creation and allocation of SDRs was in-1970- 72, totaling SDRs 9.3 billion. Again, the IMF created and allocated SDRs to the tune of 4 billion each in the years 1979, 1980 and 1981. Thus, there are now in existence a total of SDRs 21.3 billion.

Originally there have been three major ways in which the members could use SDRs:

i. Transactions with Designation:

A member country may use its SDRs to obtain foreign exchange from other member country designated by the Fund. The Fund designates a member country, with a strong balance of payments and reserve position, to provide currency in exchange for SDRs to the country wishing to convert its SDRs.

ii. Transactions by Agreement:

A member country may use its SDRs to obtain balances of its own currency held by another participant country by agreement with that participant. Under these two uses, the member nations are expected to utilise their SDRs to meet adverse balance of payments, and not to change the composition of exchange reserves.

iii. Transactions with General Account:

SDRs can be used by member countries in operations and transactions conducted through the IMF’s General Account (i.e., in settling transactions with the IMF). Since 1978, however, the IMF has allowed its members to use SDRs in a variety of other voluntary transactions and operations by agreement among themselves.

These additional uses of SDRs are:

(i) In swap arrangements, a member country may transfer SDRs to another member country in exchange for equivalent amount of currency or another monetary asset (other than gold) with an agreement to reverse the exchange at a specified future date and at an exchange rate agreed by the members.

(ii) In forward transactions, in which members can buy or sell SDRs for delivery at a future date against a currency or another monetary asset (other than gold) at an exchange rate agreed by the members.

(iii) In loans of SDRs, at interest rates and maturities agreed to by the parties. Repayment of loans and payment of interest may be made with SDRs.

(iv) In the settlement of financial obligations.

(v) As security for performance of financial obligations.

(vi) In making donations (grants).

In order to improve the working of SDRs, the IMF has taken the following measures:

(i) In value of SDRs has been linked with the standard basket of the currencies of the world’s five largest exporting countries.

(ii) In order to encourage the countries to hold SDRs, the rate of interest has been increased from 1.5% to 3.99% in 1981.

(iii) To promote the wider use of SDRs, ten official financial institutions have been designated as ‘other holders’ of SDRs.

(iv) The Fund uses the SDRs as its unit of account.

(v) The IMF intends that SDRs should become the principal international reserve asset. SDRs in India

Allocations of SDRs to India were of the order of Rs. 75.4 crores (i.e. 100.5 million U.S. dollars) in 1970-71; and Rs. 120.5 crores (i.e., 152.4 million U.S. dollars) in 1980-81. These SDRs have been directly allocated in the Government of India’s account and have been largely used for repurchase from the Fund and paying of interest. India’s reserves of SDRs, which were SDR 149 million in 1970-71, SDR 491 million in 1980-81, SDR 76 million in 1990-91 stood at SDR 56 million in 1995-96.

Merits of SDRs:

The SDR scheme has become popular because of the following merits:

(i) SDR scheme is a simple and flexible scheme which provides a new international reserve asset and a stable international currency, unaffected by the price changes in the national economies.

(ii) The scheme ensures adequate, but not excessive, growth of monetary reserves without requiring an increase in gold supply or having the obligation of key currency countries.

(iii) The countries using SDRs are not required to repay according to a fixed schedule. However, it is obligatory for them to restore their position in due course of time.

(iv) The SDRs can be used unconditionally. In other words, the user countries are not required to make changes in their domestic economic policies.

(v) Unlike the ordinary drawings on the IMF, which have to be repaid and thus lead to a temporary increase in international liquidity, the SDRs cause permanent increase in liquidity.

(vi) Holding of SDRs is beneficial to a country because they are an interest earning asset.

(vii) The SDR scheme avoids the confidence problem faced under the currency reserve standard,

(viii) The SDR scheme implies a partial demonetisation of gold. It relieves the world monetary authorities from maintaining a market value of gold.

(ix) The SDRs have the characteristic of genuine international currency. It has been willingly accepted by the member nations as a medium of exchange between the central banks.

Present Position of SDRs:

SDR is an international reserve asset, created by the IMF in 1969. Its value is based on a basket of four key international currencies. The IMF may allocate SDRs to members in proportion to their IMF quotas. There are two kinds of allocations: general allocations and special allocations. Various allocations made by the IMF are given in Table-3:

Such an allocation provides each member an asset (SDR holdings) and an equivalent liability (SDR allocation). If a member’s 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. In India’s case, the holdings are less than the allocation. Thus, India is paying interest.

Criticisms of SDRs:

In spite of great popularity of the SDR scheme, it has also been criticised due to certain drawbacks:

(i) The allocation of SDRs is not just and on equitable basis. They are allocated among the member countries in proportion to their quotas, and not according to their needs. This type of allocation specially favours the developed countries. Prof V.K.R.V. Rao has rightly observed- “An international costless reserve asset has thus been used to give more to those who have more and less to those who have less.”

(ii) In spite of the creation of this new reserve asset, the liquidity problem of inadequate reserves still continues. The SDRs are not linked with the liquidity of the countries.

(iii) The less developed countries are not provided sufficient SDRs to meet their increasing requirements of international reserves, largely because of heavy oil bills.

(iv) The scheme is purely fiduciary in nature. There is every likelihood of reduction in the public confidence in the SDRs.

(v) Unrestricted SDRs as an international reserve asset to finance the payments deficits may lead to widespread global inflation.