Sep 05

Special Drawing Rights: Not a Solution

Posted by Kristjan Velbri | Posted in Finance, Politics | Posted on 05-09-2009

During the years that preceded the current crisis, the American economy was booming. But it was not real economic growth for the money that was lent was not spent on investments but on real estate and consumer goods. Now that the bubble has burst, the Unites States administration has decided that the economy needs “stimulation”. The US has been running a budget deficit for well over a decade but with the new stimulus, the cash for clunkers (don’t forget the new “cash for refrigerators”) and many other programs that are supposed to stimulate the consumer who is already dead on the floor, the budget deficit has reached an unprecedented 1.2 trillion dollars (that’s $1,200,000,000,000).

But the US is not the only one that is suffering from the crisis and so it has become difficult for the US Treasury to finance the multiple programs put forth by the administration and the Congress. But where there is a need, there is a solution. The US “solved” the problem of financing with quantitative easing, which in English would means more like “printing money out of thin air”. Of course, once you start printing more money, you decrease its purchasing power. Since the US dollar is the predominant reserve currency of the world, it is easy to see why it makes so many politicians uneasy:

…Malaysian human-rights activist; a Filipino congressman; Zhou Xiaochuan, the head of China’s central bank; and French President Nicolas Sarkozy.

For each of them, the dollar’s role as the world’s so-called reserve currency presents inherent economic instabilities, with dangerous consequences. In both the run-up to the crisis and the crisis itself, an obsession with holding dollars roiled economies around the world. Today, those foreign countries are fearful of dollar inflation, which could decapitate their own bank reserves.[1]

Special Drawing Rights are not a real solution

For months now, political leaders from around the world have been drawing attention to the lack of discipline of the Federal Reserve. Some have even gone to the IMF and purchased special drawing rights (SDRs), the wannabe currency of the IMF. The media has been all over the issue, claiming that this is a real threat to the dollar, when it actually isn’t. Let’s take a closer look at it.

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR allocation taking effect on August 28 and a special allocation on September 9, 2009, the amount of SDRs will increase from SDR 21.4 billion to SDR 204.1 billion (currently equivalent to about $317 billion).[2]

What are these four key international currencies? Could it be that the dollar is one of them?
The percentages of the currencies that make up the SDRs are listed below? Can you guess which one of them is the US dollar? You only get one try, though.
*1st currency 44%
*2nd currency 34%
*3rd & 4th currency, each 11%

Buying special drawing rights to diversify out of the dollar makes no sense because for each dollar you get 44 cents back in the dollar, and just 56 cents back in other currencies. But because the dollar is the reserve currency of the world, the percentage is actually higher than that. Most currencies around the world are backed by other currencies or foreign debt, most of which is denominated in the US dollar. So buying special drawing rights is just a political and economic statement, but nothing more. If a central bank would want to diversify out of the dollar it would not buy special drawing rights, it would most likely buy gold or government debt from Australia, Canada and other countries whose economies are heavily linked to commodities, or in other words, insulated from dollar inflation. In fact, the same countries that have been buying SDRs or have expressed their interest in doing so, have also been active in the gold market. The Russian central bank and the Chinese alike have been hoarding gold, the latter has also been active in the silver market by publicly announcing silver bullion sales for investment purposes on its national TV (remember, anything that is on national TV in China has been previously approved). Whatever talk there is about special drawing rights, always look past the headline and see if there are real signs of diversification.

Special drawing rights purchases are a statement, gold purchases are a materialization of that statement.

1. Quoted from the Wall Street Journal: Inevitable End to Dollar’s Reserve Role
2. Definition from the IMF

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