The International Monetary Fund (IMF) was founded in 1945 as part of the Bretton Woods system agreement a year earlier. The goal of the IMF is to foster macroeconomic stability and global growth and to reduce poverty around the world.
Interestingly, economist John Maynard Keynes first proposed a supranational currency known as "Bancor" at the Bretton Woods conference, but his proposal was rejected. Instead, the IMF adopted a system of pegged exchange rates tied to the value of gold bullion. At the time, the world reserve assets were the US Dollar and gold. However, there was not enough supply of these internationally to keep sufficient reserves for the IMF to function properly. In order to fulfill its mandate, in 1969 the IMF created Special Drawing Rights, or SDRs as a supplement to help fund its stabilization efforts.
By 1973, the original Bretton Woods system had been almost completely abandoned. President Nixon restricted gold outflows from the United States, and major currencies shifted from a pegged system to a floating exchange rate regime. Still, the SDR system has been largely successful, with the IMF allocating approximately SDR 183 Billion, providing needed liquidity and credit to the global financial system.
Why SDRs Are Needed
According to the IMF, SDRs (or XDR) are an international reserve asset to supplement its member countries' official money reserves. Technically, the SDR is neither a currency nor a claim on the IMF itself. Instead, it is a potential claim against the currencies of IMF members.
An SDR allocation is a low-cost method of adding to member nations' international reserves, allowing members to reduce their reliance on more expensive domestic or external debt. Developing nations can use SDRs as a cost-free alternative to accumulating foreign currency reserves through more expensive means, such as borrowing or running current account surpluses.
The SDR is also used by some international organizations as a unit of account where exchange rate volatility would be too extreme. Such organizations include the African Development Bank, Arab Monetary Fund, Bank for International Settlements, and the Islamic Development Bank. By using SDRs, local currency fluctuations do not have as large of an impact. SDRs can only be held by IMF member countries and not by individuals, investment companies, or corporations.
As of the year 2000, four countries peg their currency to the value of an SDR, even though the IMF discourages such action.
The Value of the SDR
The value of an SDR was initially the equivalent of one US Dollar at the time or 0.88671 grams of gold. When the gold standard changed over to a floating currency system, the SDR instead became valued as a basket of world reserve currencies. Currently, this basket includes the US Dollar, Japanese Yen, Euro, and British Pound.
Every five years, the IMF reviews the components of the currency basket to make sure that its holdings represent the most widely used global currencies. It is possible that when the next review takes place in 2015, more currencies may be considered than the current four. Recent speculation that the IMF might add the Chinese yuan (CNY) would make it the first emerging currency to be added to the IMF's reserves.
The SDR's interest rate is used for calculating interest due from members of IMF loans paid from SDR holdings. SDRs are allocated by the IMF to its member countries and are backed by the full faith and credit of the member countries' governments.
Today, 1 SDR = 1.3873 US dollars, down a little more than 10% over the past 12 months versus the dollar, a result of the relative strengthening of the dollar against the three other currencies in the SDR basket.
The Bottom Line
Special drawing rights are a world reserve asset whose value is based on a basket of four major international currencies. SDRs are used by the IMF to make emergency loans and are used by developing nations to shore up their currency reserves without the need to borrow at high-interest rates or run current account surpluses at the detriment of economic growth. While SDRs themselves are not currencies, and can only be accessed by members of the IMF, they play a crucial role in maintaining macroeconomic stability and global growth by providing emergency liquidity and credit when traditional methods fall short.