What is a Special Drawing Right (SDR)?

By Cindy Ivanac-Lillig

During this financial crisis, there have been many abbreviations batted around that many of us hadn’t really heard of before. One of them, SDRs (Special Drawing Rights), has made some news recently. SDR is basically a form of “currency” that the International Monetary Fund (IMF) issues to its member countries based on a formula that includes the countries’ contributions to the fund. It is, more technically speaking, an asset that represents a basket of currencies. The current basket is made up of 44% USD, 34% EURO, 11% Yen, and 11% GBP (FOREX). It was originally designed to facilitate growth in trade. The SDRs were created in the late 60’s as a way to supplement reserves, which were basically the U.S. dollar and gold at the time (Investopedia.com).

According to the IMF, during the Bretton-Woods era, a member country needed to have official reserves (basically something widely acceptable for payment) that could be used to backstop their fixed exchange rate. As trade expanded, SDRs ensured that there were enough reserves in the system to backstop the exchange rate regimes. The Bretton-Woods system has since collapsed and many countries now allow their exchange rate to float thereby eliminating the need to have a backstop of foreign currencies /reserves to support the fixed rate. However, SDRs still remain a unit of account that IMF member countries can transact with including trading them for other hard currencies.

There have been calls to expand the use of SDRs and use them more widely as a reserve currency. One way to think about what that would look like, albeit imperfect, is to picture securitizing currencies. The idea would be that this basket would hold the blended risk of all the underlying assets (in this case the different hard currencies) and then by definition would insulate itself from any one country’s fiscal or monetary issues. There have been some “scare” signals thrown up about these proposals and what would happen to the value of the U.S. dollar if a large country decided to swap its U.S. dollar reserves for SDRs. There have been many theories as to what would happen, but I particularly liked FOREX’s Greg Michalowski’s quick take. As many have warned that the U.S. would experience very high interest rates and therefore a spectacular economic decline, Michalowski argues that the dollars received in exchange for the SDRs would also be looking to be invested as well and would likely be parked in US treasuries, thereby softening, if not, eliminating the threat of massive devaluation.

If nothing else, what we have learned in this crisis is that the underlying value of securities matters – and in this case, the health of the private and public sectors of these countries matters to all of them — so SDRs or not, real investment patterns may not change that quickly regardless of the unit of account. What do you all think?

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