What is Special Drawing Rights?
Special Drawing Right, established and created by the IMF in 1969, is a supplement reserve of foreign exchange assets that comprises of leading currencies across the globe for settling international transactions. The primary motive is to provide additional liquidity and remove several restrictions faced by the international community in growing world trade. The value of SDR is calculated on the basis of a basket of 5 international currencies – US Dollar, Chinese Renminbi, Euro, British Pound Sterling, and Japanese Yen. Currency code for SDR is XDR and numeric code is 960.
Purpose of Special Drawing Rights (SDR)
- It serves as an IMF unit of account and various other international organizations.
- The allocation of SDR plays an important role in providing liquidity and supplementing member countries with official reserves at the time of crises.
- It was created to serve as a supplementary international reserve in the context of the Bretton Woods fixed exchange rate system.
- It can be exchanged for freely usable currencies of IMF members.
The following are the salient features:
- The SDRs are allocated based on the quota system that is held by the individual member country of IMF.
- SDRs are created under a special drawing account. The resources of special drawing account are created under an agreement among the member countries as a percentage of quotas with the IMF.
- SDRs are used by member countries to meet liquidity requirements through bank credit creation. This helps the countries in supplementing the resources of the banking system to meet the liquidity needs of the country.
- The balance of payment deficit of a participant country is removed by using SDR.
- It serves as a store value rather than a medium of exchange.
- Central banks of a member country of IMF hold SDRs as their reserves along with key currencies and gold.
- SDRs are created as reserves and used for settlement of international payments.
- It helps in building confidence among members as it has been statutorily laid down.
- Member countries are obliged to accept drawing rights from members providing funds in exchange for an equal amount of convertible currency.
How Does it Work?
SDRs works voluntarily. One prescribed SDR holder and various fund members agree to buy and sell SDRs voluntarily. This fund facilitates the transactions between the member countries who seek to sell or buy SDRs and makes a voluntary agreement in the market of SDRs. If there are no voluntary buyers of SDRs, the IMF can designate members with a robust balance of payment position that helps them freely use currency and exchange for SDR. This is called the designation mechanism where SDRs can be used to obtain an equitable amount of currency. Generally, SDR allocation is based on the existing IMF quota of each country.
How to Calculate the Value of Special Drawing Rights?
The specific amount of each basket currency that is valued in US dollars is added up. The amount of currency is calculated as per the exchange rates quoted in the London market at everyday noontime. Hence the value of SDR is determined daily and is based on the weight of each currency that is included in the SDR basket such as USD – 41.73%, EURO – 30.93%, CHINESE RENMINBI – 10.92%, JAPANESE YEN – 8.33%, POUND STERLING – 8.09%. These weights determine the amount of each of the currencies included in the new SDR valuation basket since October 16.
In Moldova, the higher authorities of the nation used their SDR allocation after budget crises in late 2009 which helped them to clear the accumulated arrears of expenditures, deteriorating fiscal position, and reducing reliance on short-term domestic financing which was turning out to be expensive for the country.
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Why Are SDR Required?
Countries like China and Russia had urged the IMF to move away from the US Dollar based system, thus providing the path for the SDRs to become the de facto reserve currency of the world. These countries have been aware of the fragile economic conditions of the US. Also, Countries like China were forced to buy more US treasury debts to keeps their economy afloat. Hence the system of special drawing rights was implemented where countries like China and others could exchange the excess of Dollars they have with a basket of currencies. Where they would still end up with around 44% Dollars, this becomes a better scenario than being fully dependent on the US economy.
- Reduced Dependence on the US – Entire world will no longer be dependent on the currency of the US to trade with each other.
- Issues of Balance of Payment – Most of the balance of payment will be resolved as the US will lose its privilege and the world goes off the Dollar standards. The budget deficit problems of countries with the US get resolved.
- Stable System – Since commodities like gold, oil, food grains will not be exclusively traded in Dollars; the US government will not exert undue pressure on their prices by increasing and decreasing the supply of Dollars. Weighted Average of basket currencies makes the system more stable.
- No Gold Backing – Tangible commodity like gold makes the currency more stable but with the replacement of dollars with SDR would make one unstable system getting replaces with another slightly less unstable system.
- Money Supply Becomes an Administrative Decision – Since SDR does not have an open market, the decision of money supply, whether to be expanded or contracted becomes an administrative decision that will be taken by IMF.
- Abstract Nature – SDRs are an abstract weighted average of multiple currencies. These are not currencies on their own. Hence it becomes difficult to implement and manage at a microeconomic level.
This has been a guide to what is Special Drawing Rights. Here we discuss purpose, features, example, and how to calculate Special Drawing Rights along with benefits and limitations. You may learn more about financing from the following articles –