Print Printer Friendly Version      Email Email this Article






Challenge To The USD:
Special Drawing Rights?
Christopher Laird
March 26, 2009
Not a week after the Fed actually begins buying $300 billion of long-term Treasuries to 'lower long term rates', a rather big ballyhoo has developed around a USD alternative currency. China, among others, has suggested there be a possible world reserve currency based on SDR Special Drawing Rights at the IMF, which are based on a basket of currencies.

There have been a lot of developments affecting the US bond market and the USD, and comments by US money officials since the US just started actually implementing the Fed purchases of US long-term Treasuries. In fact, there are a lot of stories out on this, and I have been getting a lot of emails asking about what this is… so we'll make a brief survey.

Alternative to USD?

First, before we begin, its going to be a long time before a new monetary system is willingly created to replace the USD, for various reasons. But, it can never be said that a combination of black swans (unlikely events that are catastrophic) can not occur and lead to a chaotic collapse of the USD - which is more likely the way the SDR would emerge as a USD alternative, if it does, more likely than any planned transition.

Has to be forced cannot be planned

Planned transitions to replace the USD have about as much chance of being approved (done in an orderly agreed manner) as hell freezing over. Too many disparate interests are involved, and if you think the pan EU currency has trouble meeting the very disparate needs of that community, imagine the USD spanning the entire world with its supposed 'replacement'…definitely not an easy cake to bake.

So if that's what we think, then what does all the latest story on the SDR and China bemoaning the USD mean? I mean, if I think only chaos will birth a USD replacement? And that it can't and won't ever be done in an orderly way?

Well, one thing to note is that this IMF stuff really blew up in the news stories after the Fed actually took the step to monetize (purchase US treasuries directly from the Treasury). China in particular appears vexed and is leading the dialog on this new SDR from the IMF. But, in any case, I already told you my first impressions on this new significant issue, and we can now move to describing what SDRs are, before we continue our analysis…

What IMF SDRs are

Ok, first of all, with the world rapidly running out of options to stabilize things, other than a weekly new $1 trillion US plan, it appears the IMF is being tapped by our major trade partners as a vehicle that can be used to help meet the weekly crises in various countries like the Ukraine and East Europe which are just about in freefall, and can't maintain their foreign exchange deficits.

Japan recently proposed lending the IMF $100 billion worth directly. The US suggested the IMF needs $500 billion more. China states it will actively participate in an IMF bond auction to help them raise money. The IMF itself said it needs $250 billion right now to deal with the demands on it.

So, very interestingly, we have a very new development in the credit crisis, that the IMF is being tapped as a go to guy. This all speeded up rapidly after the Fed did the latest purchases of those $300 billion USTs (first auction).

Ok so China and others have explicitly stated they don't intend to bail out the US banks etc free. But, the IMF has already existing structures that can enable China, Germany perhaps, Japan and others with money still, to get involved with some form of bailouts, but not entirely tied to the USD system. IE the new IMF ideas allow a non USD solution, and might even lead to a post USD solution to the credit crisis and migration from the USD at some point. The IMF mechanisms appear to have the power to do this.

Although the SDRs, which we will detail here in a moment, have been rarely used, it's a structure that has existed since 1969 before the US went entirely off the gold standard, and is a part of the Breton Woods agreement that made the USD the world reserve currency during and after WW2.

Here is some information on SDRs from the IMF website:

Why was the SDR created and what is it used for today?

The Special Drawing Right (SDR) was created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system. A country participating in this system needed official reserves-government or central bank holdings of gold and widely accepted foreign currencies-that could be used to purchase the domestic currency in world foreign exchange markets, as required to maintain its exchange rate. But the international supply of two key reserve assets- gold and the U.S. dollar-proved inadequate for supporting the expansion of world trade and financial development that was taking place. (THIS IS LATE 1960's - Chris' comment) Therefore, the international community decided to create a new international reserve asset under the auspices of the IMF.

However, only a few years later, the Bretton Woods system collapsed and the major currencies shifted to a floating exchange rate regime. In addition, the growth in international capital markets facilitated borrowing by creditworthy governments. Both of these developments lessened the need for SDRs.

Today, the SDR has only limited use as a reserve asset, and its main function is to serve as theunit of account of the IMF and some 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. Holders of SDRs can obtain these currencies in exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges between members; and second, by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions. (Bold emphasis by Chris).

SDR valuation

The value of 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 in 1973, however, the SDR was redefined as a basket of currencies,today consisting of the euro, Japanese yen, pound sterling, and U.S. dollar. The U.S. dollar-value of the SDR is posted daily on the IMF's website. It is calculated as the sum of specific amounts of the four currencies valued in U.S. dollars, on the basis of exchange rates quoted at noon each day in the London market. …"

IMF.org

After, the US went completely off the gold standard in 1971 when Nixon unilaterally cancelled the Breton Woods agreement. AT that time, the USD was convertible to gold at the central bank level (even if US gold coins were already taken out of circulation in 1933). Well, the US at that time was running big deficits with the Vietnam War and the huge new welfare programs Johnson put it place in the 1960's 'Great Society'. The French and others were calling in US gold and it was going fast, and Nixon 'Nixed' the Breton Woods agreement. That ended the convertibility of the USD to gold directly in 1971. Since then, all the world currencies are more or less free floating on daily exchange rates.

Ok, so you look at the quoted article above and you see that before we cancelled Bretton Woods, an SDR was one USD which was based on .88 grams of gold. So when the US went off Bretton Woods, that link was broken.

The IMF then created a new version of SDR, which was based on a basket of major currencies, the Pound, Euro, Yen and USD. That was a key development. While that structure was not actively used for decades, basically just laying in wait out there, its now being looked at as a way for the IMF to fund various financial bailouts, through using SDRs (a basket currency if you like).

This is a key development. If SDRs are used instead of direct loans in, say USD, from China to the IMF, this effectively locks that portion of China's reserve assets into a currency basket, instead of the USD alone! The SDR.

The value of the SDR is set daily by the IMF and posted online. The interest rates for SDRs are also set weekly… lets not get too caught into detail here. This has to be an outline not a complete paper on SDRs and the IMF.

Again, the reason China and others are looking at this now is because a SDR allows the IMF member nations to swap foreign reserves into a currency basket called the SDR! This is a very significant development.

What that means is that, instead of loaning the IMF say $200 billion USD directly, by converting these to SDRs, they can lend this to the IMF who can then lend the currency basket value to other countries in trouble… something the world exporters definitely want to happen asap, as the credit crisis and its concurrent currency crises are not exactly waiting for anyone to figure things out.

Switching to an IMF structured world financial system for central banks, using SDR currency baskets is a way for China and others to get partly out of the USD and into a currency basket of SDRs they can claim/draw on the IMF. This is a direct threat to the USD, and the US is likely to resist this.

As we said, our initial reaction is that the SDR solution will never be agreed to without a major crisis to force action. There are so many disparate economies in the world that trying to use a single currency to address all at once is a huge problem and they will never agree. Just look at the endless problems the EU has with getting agreement on the Euro values or ECB bailouts. Any currency that spans many economies has endless structural problems and is very hobbled. This is something the Euro fans have very much underestimated. You only have to take a short look into the ever present Euro bickering for the last ten years to get the idea. The Euro is very hobbled compared to the USD in the sense the Fed/US Treasury can do whatever they want, merely with congress approval, while the ECB has to get ten something major countries to agree on monetary policy. It's been said that Bernanke has been privately getting highly frustrated with the ECB dragging its feet (rightly or wrongly).

IMF and other major trade partners already moving ahead anyway

Nevertheless, the IMF is already amassing war chest money from Japan, and China, in a $100B direct loan from Japan, and also China's proposals to buy IMF bonds in significant amounts if necessary. Since the SDR appears to be a pretty good (at first glance) mechanism for a non USD solution to further bailouts, and also helps to deal with massive USD reserves, (China can cash these at the IMF in the SDR or bond purchases to a degree, thus 'washing' the USD into a currency basket SDR, if they can get away with it).

Since the IMF and SDR have already existed for decades in agreements, they already have tacit agreement to be used should they be desired. This is key.

And, although I stated that there is a snowball's chance in hell of agreement without crisis to implement the SDR in a meaningful way, well, we do have a huge crisis don't we?

Since the US is one of the IMFs biggest participants, it's very unlikely this whole plan can be implemented without US agreement…But perhaps the US would like to shed its crown about now? It seems the only thing holding the world bank system from a perpetual holiday is the Fed standing in the way and lending to the entire world, which is not an overstatement in the least ($12 trillion and counting from the Fed/US Treasury since August 07).

But we do have a major world financial crisis with collapsing economies and many countries in currency crises which are rapidly worsening. So, I suspect the SDR issue will only increase in debate.

In any case, the IMF will apparently get major new funding between direct loans from Japan for example, or hundreds of billions worth of bonds that China and lots of others would likely buy. The SDR is not the only thing the IMF has to offer. It could use the initial funding like bonds or direct Japan like loans, whilst the SDR question is ironed out, likely in the middle of new weekly financial meltdowns here, there. and everywhere… and after a year and a half tracking the credit crisis, this writer at least is already wheezing a bit trying to keep up with things, no less the bankers all sweating it out! And rioters menacing the streets in ever larger numbers worldwide making everyone who matters antsy. There is a lot of pressure out there.

Let me tell you something. While we are all working (those of us with jobs) and living, the entire financial and political world is in a panic over what is happening, but we only see a small picture. But your leaders are panicking right now and will be for a while. Our world is in the process of turning inside out. If you think things are going to normalize much at all in the next several years, I think you will be surprised by what's going to happen.

May you live in interesting times

So, it appears we have many new 'exciting' things on the horizon this year….how soon will the SDR controversy insert itself into the credit crisis mix of weekly new bad news? Well, the SDR debate is already well underway now… so that's something. Wasn't it a Chinese saying 'May you live in interesting times.' that they used when they wanted to curse someone? (IE may you live in a war a depression or a civil war, IE 'Have a nice day.' (the shortened American version.))

The US T-Bond market here

Now, when the Fed actually just did the first part of that $300 bn T auction where they participated in the bidding, what was intended was for yields to go down. But in that auction, there was much less foreign participation, and even with the Fed bidding, the yields increased! That means this whole Fed buying up of our own debt is being viewed dimly.

So, as a result, all this talk on the SDR issue and the IMF and 'alternatives' to the USD system is fast increasing.

Now, when this issue first appeared, I initially considered it another pie in the sky idea to replace the USD. But, after China kept on that topic for two weeks now, and then seeing that the IMF indeed does have an alternative already on the books - if nations want to implement it - for a SDR currency basket unit, instead of the USD being the primary world reserve currency unit (2/3 of world CB reserves are USD, the Euro and Yen are next down) if the major world economies want this, including the US, then it can be almost immediately implemented. Please note I said 'if all the major nations agree'.

But how likely is the US to go along with this? Certainly not very enthusiastically. Thus the new game begins: How long will the world tolerate what is likely to be ever increasing US federal deficits, with the Fed becoming a major purchaser of US T bonds? We definitely are reaching a turning point here that is a new terrain compared to what we have had in place since August 07. Yes, I say this is a definite new terrain and new big development for the USD and everyone else. It all depends on where it goes.

That is now the new question before us. Will the bond markets revolt quickly? Will the SDR rapidly come to the forefront and change everything? This is a possibility (although the SDR making an immediate dent in the USD is premature at this immediate time).

Looking ahead 6 months

But, what about in 6 months? What we try to do at PrudentSquirrel is think ahead, not merely recast all the new information this week. So, the question is, how soon will SDR assert itself as a primary issue about the USD? In 6 months? And what would be the effects?

Needless to say, we can't cover everything that comes to mind here in this public article. But, we are, as usual, closely tracking this SDR issue, and the state of the US T bond markets.

First things to look for

Well, first of all, one thing to closely track will be how much money China, Japan and the others actually commit to non SDR IMF solutions. If China, Japan, and perhaps the US commit say $500 billion to the IMF in either bonds or direct loans, then the world is already moving to a non USD centered strategy, albeit it's not known yet if it can work.

Frankly, the Idea that $500 billion from the IMF will be enough to stem the already spreading damage to various nations' collapsing finances, is moot. It clearly cannot be enough. It can buy some time.

But the amount of energy China, Japan, Germany perhaps, and the US put into this alternative IMF strategy, even sans a direct implementation of SDRs will be revealing, and will show the likelihood of any switch to an actual SDR replacement (in part) for the USD system. So, we need to track the energy and money that goes into the preliminary IMF efforts. Depending on how that goes, we see the likelihood of moving to the more radical SDR solution rising and falling.

Needless to say, this entire IMF situation, with the SDR and more less drastic funding alternatives like IMF bond issues, is going to play some havoc with the USD values over the next months depending on how the IMF developments play out, not only on their end, but in the public arena and the media and seeing how China and Japan etc react.

For the time being the USD and gold, and the Yen to a point, are the goto havens. The issue we are discussing here is if the new IMF proposals are going to gain some traction. That's what we are looking for.

In case you think the Euro is an alternative, well, consider that the weaker EU nations like France are arguing heavily with the stronger EU economies like Germany over how to value the Euro and setting interest rates, and also doing any stimulus. That being the case, since the Euro cannot set a unified strategy to satisfy all its constituents, I rule the Euro out as a haven. Particularly as the world economy weakens over the next year.

All Sovereign bond markets showing severe stress

I also am becoming concerned about the world sovereign bond markets. The US T market has already been seeing significantly rising rates on longer terms. The Ten Year is up from about 2% to near 3% since January. That clearly indicates the US is tapping out the willing buyers already. With several $trillion more to roll over or be newly issued this year, well, that indicates that the US T market might just be about to hit the wall.

In the EU, Germany and the UK recently had what are called failed bond auctions. While not totally unusual, these events are rare. A failed bond auction is where say $20 billion worth are offered, but only $18 billion sell at the offered rate. Not selling it all out is called an auction failure. Ok we are not talking a 100 pct failure. At this point, when u hear failed bond auction, it only means they all did not sell out that day. So far, no emergency here with either Germany, the UK, or even the US T markets. Just some problems appearing that indicate the markets are losing faith in the Sovereign bond markets.

But, with the pressure the USD is in, and in the middle of this incomparably bad world financial crisis, these failed bond auctions are harbingers of some big trouble.

If the US in particular starts having problems rolling its Treasuries over, and the Fed buys more and more, and now with some real workable alternatives to move foreign reserves around outside the USD - in these two IMF proposals - either IMF bonds, or SDRs - new pieces are on the USD system chessboard.

New Chess game now this time

I consider these two new IMF/currency pieces to be akin to a new bishop and a castle in chess. The USD is the queen still…very much so to; it's not even under direct attack yet. But the opening game has begun.

Using the chess analogy, I would like to point out that, in the last few years, I have seen no new pieces on the world monetary chess board that even have a chance of challenging the USD. Now I see a Rook and a Bishop appearing. Before, I would have called any alternatives I have seen, including the Euro as mere pawns (if you have been reading me for years, you know that's been my view on the Euro for a long time)….so that tells you how I see these two new IMF developments, particularly with China behind the dialog. I see this new IMF story as a very significant new development, a possible game changer of magnitude I have not seen in the last year and a half, on the currency side. I have seen no possible game changers on the USD dominance even close to this IMF stuff in the last several years. Up to now it's just been a debate on the latest USD driven credit solution, and whether the ECB will ever get behind the Fed.

Up to now, the only thing holding the world financial system together has been massive public bailouts, which aren't enough anyway, with the Fed leading the charge. Now, other alternatives are being actively investigated, namely a financial/economic strategy that is not entirely USD driven, the IMF proposals,(with everything revolving so much around the USD), and - not predicated all the time on the Fed continuing to buy every market up around the world….

This is quite the interesting development.

In any case, we have a lot more on this topic at our newsletter, and a great deal of focus on world currencies and gold every week in much more detail.

The Prudent Squirrel newsletter is our financial and gold commentary. Subscribers get 44 newsletters a year on Sundays, and also mid week email alerts as needed. We alerted our subscribers April 20, 08 that the USD was bottoming. The USD has strengthened significantly since. We also alerted subscribers that gold could rally big in late Nov 08. The alerts include quick notification of important financial news developments by email. Subscribers tell us that the alerts alone are worth subscribing for.

I had one potential subscriber ask me if the newsletter has much more content than these public articles, ie, if it was worth subscribing. The answer is that the public articles have less than 10% of our research and conclusions that subscribers see, not to mention the subscriber email alerts of important breaking financial news. We have anticipated many significant market moves in the last year, such as imminent drops in world stock markets within days of them happening, and big swings in the gold markets within days of them occurring. We have also made a number of good calls on big currency swings, such as with the USD, the Euro and the Yen.

We invite you to stop by our site and have a look.


Christopher Laird
Editor-in-Chief
www.PrudentSquirrel.com

Chris Laird is not an investment advisor/professional. This article, and the PrudentSquirrel newsletter and alerts, are general market commentary only. They are not intended as specific advice. You should talk to your own investment professionals for specific advice. Information here is deemed reliable but should be verified by you if you think it's important.


Email this Article to a Friend Email
349841526