Special drawing rights

Based on Wikipedia: Special drawing rights

In August 2021, the International Monetary Fund conjured $650 billion into existence with a vote. No printing presses ran. No gold changed hands. Instead, the IMF simply credited its member countries with units of something called Special Drawing Rights—and suddenly, Liberia and South Sudan each received an amount equal to nearly a tenth of their entire economies.

This is the strange, almost magical story of the world's most obscure form of money.

Not Quite Money

Special Drawing Rights, abbreviated SDR and coded XDR in financial systems, occupy an unusual position in the global economy. They are not currency in any conventional sense. You cannot walk into a bank and exchange dollars for SDRs. No merchant accepts them. Private citizens and corporations cannot own them at all.

And yet SDRs represent real claims on real money. When a country holds SDRs, it holds a promise—redeemable with other IMF member nations—to receive actual spendable currency like dollars, euros, or yuan. The IMF acts as a kind of matchmaker, connecting countries that want to sell their SDRs with countries willing to buy them. The exchange can take several days to complete, which tells you something about how different this is from walking up to a currency exchange window.

Think of SDRs as a special kind of IOU that only governments can hold, backed not by any single nation but by the collective agreement of 190 countries that these units mean something.

Birth from Gold

The SDR was born in 1969, during the final years of the Bretton Woods system—the post-World War II arrangement that pegged currencies to the US dollar, which was itself pegged to gold at $35 per ounce. Back then, one SDR equaled exactly 0.888671 grams of gold, which worked out to precisely one US dollar.

The name itself carries the scars of diplomatic compromise. Some countries wanted the IMF to create a true international currency—something that could rival the dollar. Others balked at anything so ambitious, preferring a simple credit line. The result was this awkward term: Special Drawing Rights. Not currency. Not credit. Something in between.

An earlier proposal had called them "reserve drawing rights," but the word "reserve" proved too controversial. It implied the IMF was creating a genuine foreign exchange reserve asset, which made some member nations nervous. So "reserve" became "special," and the vagueness was the point.

When the Dollar Wobbles

SDRs tend to emerge from the shadows whenever confidence in the US dollar falters.

The first major allocation came around 1970, when the United States was running a conservative monetary policy. American officials didn't want to create more dollars, which meant there might not be enough dollar liquidity to grease the wheels of international trade. The IMF responded by distributing 9.3 billion SDRs to member countries—a new form of reserves that didn't require the US to print anything.

Then the United States reversed course, flooding the world with dollars. The potential role for SDRs evaporated almost immediately.

They resurfaced in 1978. The Bretton Woods system had collapsed, Nixon had severed the dollar's link to gold, and many countries had grown wary of accumulating even more dollar-denominated reserves. The IMF allocated 12 billion SDRs over four years.

The pattern repeated during the 2008 financial crisis. As the global economy seized up, the IMF distributed 182.6 billion SDRs—roughly $250 billion—to "provide liquidity to the global economic system and supplement member countries' official reserves." Some of this went to countries that had joined the IMF after 1981 and had never received any SDRs at all.

But the largest allocation by far came in response to the COVID-19 pandemic. In August 2021, the IMF created 456.5 billion SDRs worth about $650 billion. This single act represented roughly two-thirds of all the SDRs that had ever existed.

A Basket of Currencies

What is an SDR actually worth? The answer has evolved considerably since those gold-backed origins.

When the Bretton Woods system collapsed in the early 1970s, the IMF had to find a new anchor. In 1974, it redefined the SDR as a basket of 16 currencies. By 1981, this had been simplified to just five: the US dollar, the German mark, the French franc, the British pound, and the Japanese yen.

When the euro arrived in 1999, it absorbed the mark and franc, shrinking the basket to four currencies. Then in 2016, something significant happened: China's renminbi joined the club, bringing the basket back to five.

Today, as of August 2023, the SDR basket breaks down like this: the US dollar accounts for 43.38 percent, the euro for 29.31 percent, the Chinese yuan for 12.28 percent, the Japanese yen for 7.59 percent, and the British pound for 7.44 percent. The dollar's dominance is clear, but the yuan's presence marks a notable shift in global financial power.

Every five years, the IMF revisits these weights. To make the cut, a currency must clear two hurdles. First, the issuing country must be a major exporter. Second, the currency must be "freely usable"—widely traded in international markets and commonly held in foreign exchange reserves. China's renminbi failed this second test in 2010, which is why it had to wait until 2016 to join.

The value of an SDR in dollars fluctuates daily as exchange rates shift. On a given day, one SDR might be worth $1.44; a few months later, $1.43. The IMF publishes the current rate on its website.

Why So Few Are Used

The IMF itself describes the current role of the SDR as "insignificant." This is a remarkably candid admission for an institution that created the thing.

The problem is practical. SDRs cannot be used directly. A central bank cannot sell SDRs on the open market to prop up its currency. It cannot use SDRs to intervene when speculators attack. It cannot deploy SDRs for the dozens of daily operations that foreign exchange reserves normally serve. Every SDR must first be converted into actual currency—a process that requires finding a willing counterparty and can take days.

There's also a liquidity problem. Until the 2021 allocation, only about 204 billion SDRs existed in the world. That sounds like a lot until you compare it to the trillions of dollars sloshing around in global currency markets. A reserve asset needs depth—there must be enough of it that large transactions don't move the market. SDRs have never had that depth.

The result is a two-tier system. Wealthy nations, which hold the most SDRs, rarely bother using them. They have access to deep markets in dollars and euros and yen. The actual users tend to be developing countries, which view SDRs as what the IMF diplomatically calls "a rather cheap line of credit."

China's Vision

In 2009, as the world reeled from the financial crisis, Zhou Xiaochuan—then chairman of the People's Bank of China—published a remarkable essay. China, he argued, had accumulated enormous dollar reserves and found itself trapped. Those reserves were vulnerable to American monetary policy decisions over which Beijing had no control. What the world needed, Zhou suggested, was an international reserve currency that could "fully satisfy the member countries' demand for a reserve currency."

The SDR, he implied, could be that currency—if only it were expanded and reformed.

The proposal drew significant attention. The IMF itself published a paper exploring how the SDR's role might be enhanced. China suggested creating something called a "substitution account" that would allow countries to swap their dollar holdings for SDRs. This was not a new idea—substitution had been proposed back in 1978—but the United States had quietly killed it then, and showed little enthusiasm for reviving it.

The fundamental tension is obvious. The dollar's status as the world's reserve currency gives the United States what French finance minister Valéry Giscard d'Estaing famously called an "exorbitant privilege." America can borrow cheaply, run persistent deficits, and fund its activities by essentially exporting IOUs to the world. No country holding that privilege would eagerly surrender it to an IMF-issued alternative.

The Voting Math

Creating new SDRs requires 85 percent of the votes in the IMF's SDR Department. This is not a one-country, one-vote system. Voting power reflects each country's IMF quota—essentially its financial commitment to the fund, which roughly tracks economic size.

The United States holds 16.7 percent of the vote.

This single fact means the US effectively wields a veto over any new SDR allocation. No major expansion can happen without American consent. The 2021 COVID allocation—the largest in history—required Washington's blessing.

Once SDRs are allocated, they flow to each country in proportion to its IMF quota. This creates an uncomfortable reality: the countries that need reserve assets the least receive the most. The United States and Europe and Japan, awash in dollars and euros and yen, get the lion's share of new SDRs. The developing nations that might actually use them receive relative crumbs.

Various proposals have tried to address this inequity. In 2001, the United Nations suggested allocating SDRs directly to developing countries, which could use them as cost-free alternatives to borrowing or running trade surpluses. The idea has never gained enough traction to overcome the governance structure that gives wealthy nations control.

An Imperfect Reserve Asset

The IMF has labeled its own creation an "imperfect reserve asset." Coming from the institution that issues SDRs, this is remarkably honest.

The imperfections are structural. SDRs cannot perform the basic functions that make reserve assets useful. They cannot be deployed quickly in a crisis. They cannot be used to defend a currency. They require conversion into something else before they become useful, and that conversion depends on finding a counterparty willing to take the other side of the trade.

Originally, countries were required to maintain their SDR holdings at certain levels—the so-called reconstitution provision. If you spent some of your SDRs, you were expected to rebuild your holdings. These requirements were eased in 1981, making SDRs function less like a credit facility with strings attached and more like an unconditional asset. But the easing also removed some of the discipline that had kept SDRs circulating.

Today, countries can exchange their SDRs only for five currencies: dollars, euros, yen, pounds, and yuan. The menu is limited by design—only currencies in the SDR basket—but it means that converting SDRs can be more complicated than converting between major currencies directly.

The Percentage That Rises and Falls

There's a telling pattern in the data. Immediately after a major SDR allocation, the share of global reserves held in SDRs spikes upward. Then it begins to decline, slowly but steadily, as countries let their SDR holdings stagnate while accumulating other reserve assets.

In the early 1970s, SDRs peaked at 8.4 percent of non-gold reserves. By January 2011, that figure had fallen below 4 percent. By April 2020, just before the COVID-19 allocation, it had slipped under 3 percent.

The 2021 allocation reversed this trend dramatically, at least temporarily. But the historical pattern suggests the SDR's share will erode again as years pass between allocations and as countries accumulate dollars and euros through trade and investment.

An Idea Whose Time Has Not Come

The SDR occupies a peculiar place in international finance—too obscure to matter much in normal times, yet capable of conjuring hundreds of billions of dollars worth of reserves when crisis strikes. It is simultaneously a relic of the Bretton Woods era and a potential template for a more balanced international monetary system.

John Maynard Keynes, negotiating the post-war financial architecture, had proposed something far more ambitious: a true global currency called the Bancor, managed by an international institution that could create or destroy it to maintain stability. The SDR is a distant, diluted descendant of that vision—a compromise so compromised it barely functions as intended.

And yet it persists. When the pandemic struck, the IMF could reach for the SDR lever and, with a vote, provide $650 billion to countries around the world. No single nation had to run deficits or print money or lend anything. The SDR simply materialized, distributed according to formulas negotiated decades ago.

Whether this represents a glimpse of a more cooperative monetary future or merely a curiosity that rich nations tolerate because it costs them nothing depends largely on whether the world's appetite for dollar-denominated reserves ever truly wanes. So far, despite occasional grumbling from Beijing and elsewhere, the dollar's dominance endures. The SDR waits in the wings, imperfect and underused, ready for its moment.

That moment may never come. Or it may arrive suddenly, triggered by some crisis that makes the dollar look less safe than SDRs backed by the collective faith of 190 nations. In international finance, improbable things happen with unsettling regularity.