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Monday, March 30, 2015

SDR FUNDAMENTALS & FUTURE ANNOUNCEMENTS by JC Collins

SDR FUNDAMENTALS & FUTURE ANNOUNCEMENTS

SDR FUNDAMENTALS & FUTURE ANNOUNCEMENTS

By JC Collins
This post is specifically structured to help readers, who may be unfamiliar with the SDR and how it works, to become more educated on the history of the SDR, and what it’s future characteristics and functions will be.  As we move through the year and to the ultimate restructuring of the global monetary system, it will be important for people to understand what they can do, and how they can do it, to protect their wealth and remain viable throughout the multilateral transition.
Many times I have been asked what the average person could do to protect themselves during this transition, and just as many times I’ve given broad statements about diversification.   Within the coming weeks there will be an announcement on PoM containing information on what options are available.  There has been much going on behind the scenes which has been building on the realities of the multilateral transition, which, based on the events and announcements over recent weeks, can no longer be denied.

But first, let’s review some of the fundamentals of the existing SDR, and the upcoming new SDR.
Summary – How will a new SDR composition contribute to reduced volatility for central banks and other large international financial institutions? The ability of the SDR to bring further diversification and stability to the global financial system comes from its structure as a basket of currencies.  The value is based on the weights of the currencies in the basket composition.
In 2011 the International Monetary Fund called for the replacement of the USD as the world’s primary reserve currency.  The SDR, which represents a potential claim on the currencies of IMF members, was considered to be the only viable alternative to the USD. The SDR, through its structure as a basket of currencies, is able to contribute to the stabilization of the global financial system through currency diversification, and can be used as a less volatile alternative to the dollar.
Once established as the global reserve asset, the SDR will be freely converted into whatever currency a borrower member requires, at exchange rates which are based on the weighted composition of the reserve currencies which make up the basket.
Along with correcting global imbalances, the goal is also to have an international reserve asset for central banks which will better reflect the global economy, accounting for the growth in the emerging markets, such as China and India.  The dollar, which is vulnerable to swings in the domestic economy and policy changes of the United States, does not meet the demands required of a reserve asset.
Along with a broader diversification of the SDR basket composition, the issuance of SDR-denominated bonds will also help to reduce central bank dependence on US Treasuries, which in turn will help limit the balance of payments deficit which the United States has been running for decades. The diversification of foreign reserve accounts based on the SDR will be more effective with a basket composition that is expanded from its current weighting.
With a change in global reserve currency, such assets as oil and gold will also be priced in SDR.
Over the next few years the financial world will see the creation of an additional SDR 1,442,742,000,000 ($2 trillion USD) , bringing further diversification to the global monetary system.  This massive allocation will also facilitate the SDRM, Sovereign Debt Restructuring Mechanism, which will address the growing sovereign debt crisis.
History of the SDR – In 1968 the United States supported a proposal made by the International Monetary Fund to create a new international reserve asset called the Special Drawing Right.  The purpose of the SDR (currency code XDR), which became operational in 1969, was to reduce and eliminate the balance of payments deficits which America was building under the original Bretton Woods structure which had been agreed upon in 1944 by 44 Allied countries.
Initially the SDR valuation was equivalent to 0.888671 grams of fine gold, which was also the equivalent of $1.00USD. After the collapse of Bretton Woods between the years 1971 and 1973 the SDR valuation was changed to the basket of currencies structure.
The basket valuation and weights went through several changes over the years, with adjustments made every 5 years.  As of January 1, 2011, the SDR basket composition was as follows:
SDR Basket

The SDR basket composition will once again be adjusted with the first formal meeting to review the weights taking place in May, 2015.  The composition will be confirmed in October, 2015, with the changes taking effect on January 1, 2016.

SDR Review – The upcoming SDR review will see the inclusion of the Chinese yuan, or RMB, in the basket composition.  Both the IMF and China have been recently discussing this fact and have openly acknowledged that it will happen.
The renminbi has been dramatically internationalized since the last SDR review in 2010.  The volume of international use of the Chinese currency has been expanded with the utilization of Bi-Lateral Swap Agreements (BSA’s) between the People’s Bank of China and other central banks around the world, including the United Kingdom, Canada, Switzerland and Germany.  See post Renminbi Is Already A De Facto Reserve Currency.
The RMB is now the 5th most traded currency in the world as of March, 2015, and will see additional increases in the coming months and years.
In 2009, as response to the financial crisis, Zhou Xiaochuan, Governor of the People’s Bank of China, gave a speech titled “Reforming the International Monetary System”.  In that speech he emphasized the following:
  1. The need to create and utilize a supra-sovereign international reserve asset which is removed from the inherent deficiencies caused by the international use of national credit based currencies.
  2. The potential of converting a percentage of foreign reserves into SDR.
  3. Expanding the SDR to include, as a means of payment, currency of denomination for securities, commodity denomination, and elevation to the role as primary global reserve currency.
These mandates align with the statements from the International Monetary Fund in 2011 on the need for changes to the international reserve currency system.  There are several scenarios that changes to the SDR composition could encompass, with weights adjusted depending on what other currencies, or assets, are included in the basket.
One such scenario, which is virtually guaranteed, is the addition of the RMB.  Possible weighting with this scenario could look like this:
Scenario 1
Another possible scenario would be to include, in addition to the RMB, the Canadian dollar (CAD) and the Swiss franc (CHF).  Canadian dollars have slowly been accumulating in the foreign reserve account around the world, same as the Australian dollar, and the Swiss franc recently ended its peg to the euro, which could be in preparation for its inclusion into the SDR basket, as having a currency pegged to another currency in the basket would not create the necessary diversification and stability.  See post The Real Reason the Swiss Peg Ended.

The Chinese renminbi would also have to end its managed peg to the USD in preparation for the SDR composition.  See post When Will China End the Dollar Peg.
Scenario 2
A third scenario worth considering is that along with the currency composition above, gold could also be included into the SDR basket to bring additional stability outside of the currency class itself.  We could also see, in place of gold being included directly into the basket, the currencies themselves partially supported by gold, much like the USD in the original Bretton Woods Agreement, and the initial structure of the SDR back in 1969.

Scenario 3
In the coming months there are going to be dramatic changes in the world and how the existing monetary system functions.  Whatever the basket composition ends up being, on January 1, 2016, the new SDR will come into effect and nothing will be the same after.

As mentioned, in the coming weeks there will be some exciting announcements on PoM in regards to the new SDR and what the average person can do to capitalize on the multilateral transition, as well as protect themselves from any volatility that may take place.
Stay tuned…    – JC
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