Special drawing rights sdr

Special Drawing Rights (SDR): Definition, Formula, Example, and FAQs

Special Drawing Rights (SDRs) are an international reserve asset created by the International Monetary Fund (IMF) to supplement its member countries' official reserves. While not a currency, SDRs represent a potential claim on the freely usable currencies of IMF members and can provide a country with international liquidity. They function as a unit of account for the IMF and other international organizations, playing a crucial role in international finance.⁴⁹, ⁵⁰, ⁵¹

History and Origin

The concept of Special Drawing Rights emerged from the challenges faced by the global monetary system in the mid-20th century. During the Bretton Woods system of fixed exchange rates, the primary reserve assets were gold and the U.S. dollar. However, concerns arose in the 1960s about the adequacy of existing reserve assets to support the expansion of world trade and the growing global economy.⁴⁸

To address this potential shortage of foreign exchange reserves and ensure global financial stability, the IMF created SDRs in 1969.⁴⁶, ⁴⁷ The first allocation of SDRs occurred on January 1, 1970, with the initial rationale being the prospect of a reserve shortage due to stringent U.S. monetary policy at the time.⁴⁵ Although the Bretton Woods system collapsed in the early 1970s, leading to a shift toward floating exchange rates, SDRs continued to exist, primarily serving as the IMF's unit of account.⁴⁴ A significant development in the SDR's history was the inclusion of the Chinese Renminbi (Yuan) in its valuation basket in October 2016, marking a milestone in the integration of the Chinese economy into the global financial system.⁴¹, ⁴², ⁴³ This decision followed extensive discussions and China's efforts to liberalize its currency and financial markets.³⁹, ⁴⁰

Key Takeaways

Special Drawing Rights (SDRs) are an international reserve asset created by the International Monetary Fund (IMF) to supplement the official reserves of its member countries.³⁸
The value of an SDR is derived from a currency basket comprising five major currencies: the U.S. dollar, Euro, Chinese Yuan (Renminbi), Japanese Yen, and British Pound Sterling.³⁷
SDRs are not a currency themselves, but rather a potential claim on the freely usable currencies of IMF members, providing liquidity to countries.³⁵, ³⁶
Allocations of SDRs are made to IMF members in proportion to their existing quotas, which broadly reflect their relative economic positions.³³, ³⁴
SDRs serve as the unit of account for the IMF and other international organizations.³²

Formula and Calculation

The value of the Special Drawing Rights (SDR) is determined daily based on a weighted average of a basket of five major international currencies. The weights assigned to each currency in the basket are reviewed and adjusted periodically by the IMF, typically every five years, to reflect their prominence in international trade and financial systems.³¹

The value of one SDR is calculated as follows:

SDR_{value} = \sum_{i=1}^{5} (C_i \times E_i)

Where:

(C_i) = the amount of currency (i) in the SDR basket
(E_i) = the market exchange rate of currency (i) against the U.S. dollar

For example, the specific amounts of each currency in the basket, along with their assigned weights, are set by the IMF Executive Board. The interest rate on the SDR also reflects a weighted average of short-term interest rates in the money markets of the currencies in the basket.³⁰

Interpreting the SDR

While SDRs are not a traditional currency, their value reflects the strength and stability of the major global currencies they comprise. Countries holding SDRs can exchange them for freely usable currencies with other IMF members, often facilitated by the IMF, to adjust their foreign exchange reserves or meet balance of payments needs.²⁹

A country's holding of SDRs indicates its capacity to access these hard currencies when required, contributing to its overall international liquidity. For instance, an increase in a country's SDR allocation can enhance its reserve buffers without incurring new external debt, which is particularly beneficial during periods of economic strain.²⁸

Hypothetical Example

Imagine the hypothetical country of "Diversifia," an IMF member. Diversifia is experiencing a temporary shortfall in its hard currency reserves due to an unexpected surge in imports and a decline in export earnings, impacting its balance of payments. To stabilize its financial position, Diversifia decides to utilize its Special Drawing Rights.

Diversifia holds SDR 100 million in its accounts with the IMF. It needs to acquire U.S. dollars to pay for critical imports. The IMF facilitates a transaction where another IMF member country, "Stabilia," which holds excess U.S. dollars, agrees to exchange them for Diversifia's SDRs. The exchange is based on the prevailing SDR valuation, which is a composite of the five major currencies. If, for instance, the SDR value on that day is equivalent to 1.35 U.S. dollars, Diversifia would exchange its SDR 100 million for USD 135 million. This transaction allows Diversifia to replenish its foreign exchange reserves and continue its international trade obligations without resorting to external borrowing or depleting its existing hard currency holdings.

Practical Applications

Special Drawing Rights are primarily used by official entities, such as central banks and governments of member countries, and approved international organizations. Their practical applications include:

Supplementing Reserves: SDRs serve as a crucial supplement to countries' foreign exchange reserves, especially during times when traditional reserve assets like the U.S. dollar or gold might be scarce.²⁶, ²⁷
Providing Liquidity: Allocations of SDRs can provide unconditional liquidity, helping countries address sudden external shocks or financial crises, and supporting global economic stability.²⁴, ²⁵ For instance, in August 2021, the IMF approved a historic SDR 456 billion (approximately US$650 billion) allocation to help countries cope with the impact of the COVID-19 pandemic.²¹, ²², ²³ The World Bank also supported this allocation to boost global recovery.¹⁹, ²⁰
Unit of Account: The SDR acts as the unit of account for the IMF itself, as well as for various other international agreements and financial transactions.¹⁸
Supporting Development Finance: Richer countries can voluntarily channel their SDR allocations to poorer countries, often through IMF trusts like the Poverty Reduction and Growth Trust (PRGT) and the Resilience and Sustainability Trust (RST), to support concessional loans for development and climate action.¹⁵, ¹⁶, ¹⁷

Limitations and Criticisms

Despite their intended benefits, Special Drawing Rights face certain limitations and criticisms:

Not a Freely Tradable Currency: SDRs are not a currency that can be directly used for private transactions or held by private entities. They can only be exchanged between official holders, limiting their direct utility in the broader financial markets.¹³, ¹⁴
Limited Circulation: The total amount of SDRs in circulation is relatively small compared to the vast sums of global foreign exchange reserves held in national currencies. This limited circulation can restrict their impact as a universal reserve asset.¹²
Allocation Discrepancy: SDR allocations are based on IMF quotas, which reflect a country's economic size and financial contribution to the IMF, not necessarily its financial needs. This means wealthier countries receive the largest share of any allocation, even if they do not require additional reserves, while lower-income countries, which might have greater financing needs, receive a proportionally smaller share.⁹, ¹⁰, ¹¹
Underutilization by Developed Countries: Developed countries, which hold the greatest number of SDRs, are often less likely to use them, preferring to rely on their substantial holdings of national currencies.
Debate on Sufficiency: While beneficial, large allocations like the one in 2021 have been criticized by some as insufficient to meet the actual financing needs of low- and middle-income countries, particularly during major global crises like the COVID-19 pandemic.⁸ Some argue that more significant reforms are needed to make SDRs a more impactful tool for development finance.⁷

Special Drawing Rights (SDR) vs. Reserve Currency

Special Drawing Rights (SDRs) and a reserve currency both play roles in international finance, but they differ fundamentally in nature and function. A reserve currency, such as the U.S. dollar or the Euro, is a national currency held in significant quantities by central banks and other monetary authorities as part of their foreign exchange reserves. It is widely used in international trade and financial transactions and is typically seen as a safe and stable store of value.

In contrast, SDRs are an artificial international reserve asset created by the IMF. They are not a physical currency issued by any country or a claim on the IMF itself. Instead, they represent a potential claim on the freely usable currencies of IMF member countries. While a reserve currency circulates freely in global markets and is used directly for payments, SDRs are primarily an accounting unit and a means by which members can access other currencies, exchanged only between official entities. The value of a reserve currency is determined solely by market forces and the economic health of its issuing country, whereas the value of an SDR is derived from a basket of several leading reserve currencies.

FAQs

What is the primary purpose of Special Drawing Rights?

The primary purpose of Special Drawing Rights (SDRs) is to supplement the existing foreign exchange reserves of IMF member countries, providing them with additional liquidity and helping to ensure stability in the global economy.⁶

Are Special Drawing Rights a real currency?

No, Special Drawing Rights are not a real currency. They are an international reserve asset and a unit of account for the IMF, representing a potential claim on freely usable currencies rather than a currency itself.⁵

How is the value of an SDR determined?

The value of an SDR is determined daily based on a weighted average of a currency basket comprising five major currencies: the U.S. dollar, Euro, Chinese Yuan (Renminbi), Japanese Yen, and British Pound Sterling.⁴

Who can hold and use Special Drawing Rights?

Only IMF member countries and a limited number of approved international organizations can hold and use Special Drawing Rights. Private entities, individuals, or corporations cannot directly hold or transact in SDRs.², ³

Why were Special Drawing Rights created?

SDRs were created in 1969 to address concerns about the adequacy of existing global foreign exchange reserves, primarily gold and the U.S. dollar, to support the growth of world trade and the global economy under the fixed exchange rate system of the time.¹