SDR and Relative importance of currencies

  • June 1, 2022
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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SDR and Relative importance of currencies

Why in the news?

Recently, the IMF has announced an updated basket with new currency weights that will come into effect on August 1.

Details:

Based on data for the five-year period 2017- 21, the updated basket assigns higher weights for the US dollar and the Chinese RMB, while that for the pound, the euro, and the yen have been reduced.

The IMF acknowledges that in the future, there may be some disruptive impact on the relative roles of currencies due to developments in fintech, inflation, potential economic and financial fragmentation, sanctions, and others. But, so far, their impact on the SDR composition has been minimal.

Indicates?

The RMB is now the third most important currency in the IMF’s SDR basket — next to the US dollar and the euro.

As the weights of currencies included in the basket should reflect their relative importance in the world’s trading and financial system, this is another testimony to China’s increasing importance in the global economy.

While the RMB is becoming increasingly important in international trade in goods and services, the dollar continues to be the overwhelming favourite for global financial transactions.

The weights of different currencies in the SDR basket are determined by a formula involving four factors for a currency: These are along their weights:

  • Volume of exports in that currency (50%)
  • Three financial indicators weightage of 1/6 each.
  • Forex reserve holdings denominated in that currency;
  • Foreign exchange turnover of that currency; and
  • Sum of international banking liabilities and debt securities denominated in that currency.

Figure- growth of Chinese RMB in various indicators

  • For the period 2017-21, rapid export expansion by China led to exports in RMB reaching a share of 22.3 per cent in global exports, which is just below dollar  and euro denominated exports.
  • But for the financial indicators, China appears to be a much smaller player in the international economy. 
    • Only 2.2 per cent of global forex reserves were maintained in RMB for 2017-21 compared to 64.8 for the dollar.
    • Forex transactions and international banking liabilities and debt securities, the shares of RMB-denominated transactions are significantly smaller than the comparable numbers for the dollar
Concept:

  • The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves.
  • The SDR was initially defined as equivalent to 0.888671 grams of fine gold—which, at the time, was also equivalent to one U.S. dollar. After the collapse of the Bretton Woods system, the SDR was redefined as a basket of currencies.
  • The value of the SDR is based on a basket of five currencies—the U.S. dollar, the euro, the Chinese renminbi, the Japanese yen, and the British pound sterling.
  • The yuan’s entry into the SDR signaled it became one of the five global reserve currencies in 2016, after years of effort by Chinese authorities to promote its global use.

  • Currencies included in the SDR basket have to meet two criteria: the export criterion and the freely usable criterion. 
    • A currency meets the export criterion if its issuer is an IMF member or a monetary union that includes IMF members, and is also one of the top five world exporters.
    • For a currency to be determined “freely usable” by the IMF, it has to be widely used to make payments for international transactions and widely traded in the principal exchange markets. Freely usable currencies can be used in Fund financial transactions.
  • The SDR serves as the unit of account of the IMF and other international organizations.
  • The SDR is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. SDRs can be exchanged for these currencies.
  • The SDR basket is reviewed every five years, or earlier if warranted, to ensure that the basket reflects the relative importance of currencies in the world’s trading and financial systems.
  • The actual weights of currencies in the basket fluctuate as cross-exchange rates among the basket currencies move. The value of the SDR is determined daily based on market exchange rates.

SDR allocation:

The Articles of Agreement, determine that under certain conditions the IMF may allocate SDRs to members participating in the SDR Department.

  • A general allocation of SDRs must be consistent with the objective of meeting the long-term global need to supplement existing reserve assets.  The allocation is distributed to member countries in proportion to their quota shares at the Fund.
  • A special one-time allocation in 2009 enabled countries that joined the IMF after 1981 (i.e., after previous allocations) to participate in the SDR system on an equitable basis.

Participating members and prescribed holders can buy and sell SDRs in the voluntary market. If required, the IMF can also designate members to buy SDRs from other participants

SDR and Relative importance of currencies