What Are SDRs And Why Are They Being Talked About?

An SDR is defined as “a form of money that the International Monetary Fund’s board of governors can create by crediting accounts of the Fund’s member states, at an exchange rate determined by a basket of major currencies. ”

It is designed to provide an alternative to being tied to a particular currency like the US dollar.

How do they fit in with the comment by Geithner this morning?

China has a dilemma as it is a large holder of dollars and it is concerned about that exposure given the US current expansionary policy (printing money which should depreciate dollar holdings).  China could diversify out of the dollar into the EURO by selling dollars and buying EUROs.  However, if it did that the dollar could decline substantially while the value of the EURO would rise substantially.  This could further destabilize the European economy as the higher EURO hurts their export market, and lowers inflation further (they are already starting to be concerned about deflation).

For the US, inflation can rise (lower dollar increases the price of imports) and this in turn could lead to higher interest rates and choke off its economy when a stronger economy is needed not just for the US but for the world economy.

As an alternative, China could convert dollars into a basket of currencies called an SDR at the IMF.   China would be diversified into a basket of currencies at a blended interest rate, without having to sell the dollars (a simple swipe of the pen on the books of the IMF would swap China’s US dollars into an SDR at a blended exchange rate).  The IMF would in turn take the dollars and invest them in US treasuries.

So although the talk of this action caused the dollar to decline at first, it seems that in reality if this happened in the real world, there might actually be more stability then the alternative.

Geithner’s suggestion that the US would be opened to a SDR linked currency system is probably the right gesture given the policy the Treasury and the US Fed is adopting at the moment.  China is a huge trading partner and a huge buyer of US Treasuries.  If they were to decide they do not want the dollars, bond prices would decline (interest rates would rise),  the dollar will decline.

A more stable mechanism would be to let China convert to a SDR in lieu of selling dollars outright.

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