The Special Drawing Right (SDR) is a fascinating, yet often misunderstood, component of the international financial system. While not a currency itself, the SDR plays a crucial role as an international reserve asset, supplementing the official reserves of member countries of the International Monetary Fund (IMF). Its value is determined by a basket of major world currencies, including the US dollar, the Euro, the Chinese Renminbi (Yuan), the Japanese Yen, and the British Pound Sterling. Let’s delve into what the SDR is, its purpose, and how currencies like the Euro and Chinese Yuan fit into this important financial instrument.
What Exactly is the SDR?
Think of the SDR as an international reserve asset, created by the IMF to supplement member countries’ official reserves. It’s important to understand that the SDR is not a currency you can hold in your wallet. Instead, it functions more like a unit of account at the IMF and other international organizations. Its value isn’t fixed to gold anymore, as it was initially, but is now calculated daily based on the exchange rates of a basket of five major currencies:
- US Dollar (USD)
- Euro (EUR)
- Chinese Renminbi (CNY)
- Japanese Yen (JPY)
- British Pound Sterling (GBP)
This basket approach ensures the SDR’s value reflects the global importance of these key economies. For those interested in deeper learning, the IMF offers resources to explore the SDR further.
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The Purpose Behind the SDR
The IMF established the SDR in 1969, a time when global currencies were pegged to gold, and the US dollar was the dominant reserve currency. Initially, the SDR was defined as equivalent to a specific amount of gold, which also equaled one US dollar.
However, when fixed exchange rates were discontinued in 1973, the SDR’s definition evolved. It was redefined to represent the value of a basket of leading world currencies. This shift made the SDR more adaptable to the changing global financial landscape. While not a currency itself, the SDR acts as an asset that countries holding it can exchange for actual currency when they need it. Furthermore, the SDR serves as the unit of account for the IMF and various other international organizations, providing a stable and standardized measure in international finance.
Who Can Actually Hold SDRs?
It’s important to note that SDRs are not for individuals or private companies. They are primarily held by IMF member countries and the IMF itself. The IMF also has the authority to approve other entities, known as “prescribed holders,” such as central banks and multilateral development banks, to hold SDRs. As of February 2023, there were 20 organizations with this prescribed holder status.
While both participating member countries and prescribed holders can engage in buying and selling SDRs, there are some key differences. Prescribed holders do not receive SDR allocations, and they cannot request SDR exchanges through the designation process that is available to member countries. This distinction highlights that SDRs are primarily designed to support IMF member countries in managing their reserves.
Understanding SDR Value and the Role of the Euro and Chinese Yuan
The value of the SDR in US dollar terms is calculated daily based on the spot exchange rates observed around noon in London. This daily valuation is publicly available on the IMF website, ensuring transparency and easy access to this crucial information.
The composition of the SDR basket is reviewed by the IMF every five years, or more frequently if deemed necessary. This review process ensures the basket continues to accurately reflect the relative importance of currencies in the global trading and financial systems. A significant development in this review process was the inclusion of the Chinese Renminbi (RMB) into the SDR basket in October 2016. This decision recognized the growing international role of the Chinese Yuan. Alongside the RMB’s inclusion, the three-month yield for China Treasury bonds was incorporated into the basket used to determine interest rates on SDRs.
During these reviews, the IMF considers the criteria for selecting currencies for the SDR basket and the initial weights assigned to each currency. While the currency amounts within the basket remain fixed for each five-year valuation period, the actual weight of each currency fluctuates with exchange rate variations. This means the daily value of the SDR is directly influenced by the exchange rates between the currencies in the basket, including the Euro To Chinese Yuan, Euro to USD, and Chinese Yuan to USD rates, among others.
To be included in the SDR basket, a currency must meet two key criteria, reflecting its international usage and importance in the global financial system.
Quinquennial SDR Valuation Review: Adapting to Global Financial Shifts
The IMF conducts a comprehensive review of the SDR valuation method every five years. In March 2021, due to the urgent need to address the COVID-19 pandemic, the IMF Executive Board extended the existing SDR valuation basket until July 31, 2022. This effectively adjusted the five-year cycle of SDR valuation reviews.
The review concluded in May 2022 maintained the existing currencies in the SDR basket – including the Euro and Chinese Yuan – but updated their weights to reflect changes in the global economy. The revised basket took effect on August 1, 2022. More detailed information regarding these reviews and historical weights is available from the IMF.
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General Allocations of SDRs: Boosting Global Liquidity
The IMF’s Articles of Agreement allow for the allocation of SDRs to member countries – but not to prescribed holders – under specific conditions. There have been four general allocations of SDRs to date. Most recently, in 2021, the IMF Board of Governors approved a substantial general allocation of approximately SDR 456 billion (equivalent to US$650 billion) to enhance global liquidity. This significant distribution, the largest SDR allocation in the IMF’s history, was instrumental in helping countries manage the economic fallout from the COVID-19 pandemic. Prior to this, a general allocation of around SDR 161 billion (US$250 billion) in 2009 helped bolster liquidity during the global financial crisis.
General SDR allocations require broad consensus among IMF members and are distributed to member countries in proportion to their quota shares at the IMF, ensuring equitable distribution based on their stake in the global financial institution.
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Special SDR Allocation: Addressing Historical Inequities
In 2009, the IMF also implemented a special one-time allocation of SDR 21.5 billion (approximately US$33 billion). This special allocation aimed to make the distribution of SDRs more equitable for countries that joined the IMF after 1981. At that time, over one-fifth of the IMF’s member countries had never received an SDR allocation, highlighting a historical disparity that this special allocation sought to address.
SDR Interest Rates: The Cost of Holding and Using SDRs
Does the IMF charge interest on SDRs? The answer is yes, and the SDR interest rate (SDRi) is a key mechanism within the SDR system. The SDRi serves as the basis for calculating interest charged and paid to members, including on regular borrowing from the IMF and on SDR holdings.
The SDR interest rate is determined weekly and is based on a weighted average of interest rates on three-month debt in the money markets of the currencies included in the SDR basket. This calculation ensures the SDR interest rate reflects prevailing market conditions in the major economies whose currencies comprise the basket.
SDR ALLOCATIONS AND HOLDINGS
In conclusion, the SDR is a vital international reserve asset, and understanding its composition, valuation, and function is crucial for grasping the dynamics of the global financial system. The inclusion of the Euro and Chinese Yuan in the SDR basket underscores their significance in international trade and finance, and their exchange rates are integral to determining the SDR’s daily value. For further exploration of related topics, the IMF provides a wealth of resources.
This page was last updated in January 2023.
