I have been taking the INET course on Money and Banking by Perry Mehrling. It is a superb course and has introduced me to this concept that the financial/monetary system requires elements of elasticity and discipline to live.
In Lecture 14 of the course he introduced why the Keynes concept of the Bancor (more elastic system) was trumpted by the SDR (more disciplined system) concept for creating this higher level of money in the hierarchy between gold and national currencies and this post is being made to capture that idea. In fact he occassionaly shows Gold and SDRs (paper gold ?) as being equivalent but that is another future discussion!
Of course the BANCOR favoured the deficit nations since it provided for no limit on any required monetary system elasticity (bank of last resort) and dealt with the asymmetry issue of rebalancing the global monetary system by actually charging the surplus nation a negative interest rate so that they would spend the money. Perry’s arguement was that the US looked at the Keynes model and concluded that since they expected to be the major surplus nation that this concept was not really in their better interests. Hence it did not happen.
Instead what ultimately developed was a paper reserve called the SDR (Special Drawing Rights). It was more like a gold standard in that there would only be a fixed quantity created. SDRs would have the qualities of a more disciplined system and would benefit the higher GDP nations as opposed to the emerging nations because in the new IMF model the highest GDP nations (read USA) received the biggest share of the SDR allocations (paper gold) being created. That way all those SDRs allocated to the USA could be loaned by the USA to deficit developing countries when needed ?!!
Today the USA is the major deficit nation but continues to receive the largest allocation of SDRs. No surprise that China is fighting for a different system !? The SDR is hence not disciplined or elastic enough in it’s current construct. So what is the future ? Some say it is adding the RMB to the SDR basket of currencies and increasing the number of SDRs allocated to nations ?
Of course Perry Mehrling indicated that the entire gold standard system could have been saved (at any time since the 1920s) by simply revaluing gold to a higher price ! Is that still part of the ultimate fix ? Gold priced higher as the discipline and maybe a BANCOR like currency (not based on any nation’s currency) as the next layer in the new hierarchy of money ?!
Regulators are beginning to express concerns about a potential collateral crunch causing a new market seizure. One solution might be to increase the use of SDRs.
THE SYSTEM NEEDS GOOD COLLATERAL
The collapse of Lehman caused a nasty back-up in the system.
Extended collateral chains of bonds and cash were severed and withdrawn because no one trusted their counterparties. This caused the great trading money-go-round that finances broker-dealers and hedge funds to grind to a shuddering halt. Liquidity collapsed, so even non-leveraged investors could not get business done. The bid-offer spread, on everything from cash bonds through to exotic options, gapped. The inherent fragility of the financial system was laid bare.
Since those dark days, regulators have been engaged in an effort to build greater resilience. One of the most important building blocks of this new financial architecture is collateral.
SDR BONDS AS COLLATERAL
Since we are delving around in relatively esoteric parts of global finance, let’s turn next to SDRs (special drawing rights). Strictly speaking the SDR is not a currency, rather a claim on member central banks maintained by the IMF. But it is a quasi-currency. In 2011 the IMF issued a paper, Enhancing International Monetary Stability – A Role for the SDR. It raised the prospect of issuing bonds in SDRs as a means of financing the IMF.
THE SDR BONDS WOULD BE AAA RATED COLLATERAL
What is certain is that SDR-denominated bonds would be triple-A rated. As such they would be in huge demand, for several reasons. One has already been stated: triple-A is becoming as rare as hen’s teeth. But there are other, subtler and interrelated, explanations. The likely biggest buyers of these bonds are asset pools that care most about return of capital – in particular, reserve managers at central banks and sovereign wealth funds. These entities are also looking for a way to diversify their large US dollar holdings.
THE SDR NEEDS TO BE REBALANCED TO INCLUDE THE RENMINBI AND AS A CONSEQUENCE THE US DOLLAR DEPRECIATED !
There is a small snag. The SDR is not as diversifying as it might be. It is made up of a currency basket of US dollar, euro, yen, and sterling. The dollar is 41.9% of the basket. If you add in sterling, the basket is more than 50% composed of net debtors. The eurozone is broadly in balance. By contrast, China has a net foreign asset position of more than 50% of GDP. In 2009 the chairman of the People’s Bank of China, Zhou Xiaochuan, called for the SDR to become a new global reserve currency. Implicit in his comment was the inclusion of the renminbi in the SDR basket. The next review of its constituents is in 2015.
Check out this IMF Fact Sheet and the short 2 minute video.
It is so amazing to realize that the IMF has allocated more SDRs to the USA than any other country !! Why ? Because the process is primarily based upon GDP. The more GDP your country has the higher the percentage share of SDRs you receive whenever the boys get together, create them out of thin air and hand them out ! It usually only happens with financial disasters like in 2009.
Remember a SDR is an international reserve currency which can be loaned between countries and exchanged into the 4 core currencies. Not sure why a country would borrow SDRs from another member country, like the USA, but I guess being given the right to convert them into US dollars is a good incentive !
Now consider that back in 1969 that 1 SDR = $ 1 US Dollar and today it is more like 1 SDR = 1.5 US Dollar.
So what does that really mean ? Well it means that when the US Treasury hands over a SDR Certificate to the FED (monetize them) instead of getting 1 US Dollar per SDR as it could in 1969 it can today get 1.5 US Dollars for those older issue SDRs!! Is that bad ? Not for the US Treasury. As long as they continue to get the most Allocated SDRs, rarely send them over to the FED for cash (monetize them) and they continue to appreciate in terms of the US Dollar it means they are making out like bandits if they can hold out until they are needed by the US during some big reset ?!!! Has no one figured that out ?
But what happens if you are a country who has borrowed SDRs? For example a country borrowing SDRs in 1969 and coverting them into US dollars has to actually pay back 50% more US dollars at todays exchange rate before interest !!?? Borrowing SDRs does not sound like a great deal but maybe I have missed something ????