Way back in 1944, when the world economy was just starting to recover from the effects of World War II, 29 countries got together at the Bretton Woods Conference to create the International Monetary Fund (IMF). The IMF would be responsible for promoting international monetary cooperation and help re-build the economies of the war-ravaged countries.
At that time, all currencies were pegged to the US dollar, which in turn was pegged to gold. Central banks viewed dollars as equivalent to gold and held them as reserves. In theory, every dollar was backed by gold and redeemable at the rate of $35 per ounce of gold. At the time, the US was the world’s most dominant power, unscathed by war. European gold had fled to the US for safe-keeping during the war.
With such a huge hoard of gold, it was expected that the dollar would be as good as gold. Unfortunately, the US started to abuse its dominant position. The circulation of dollars increased, not least due to their foreign (mis)adventures in Vietnam, and the dollar peg started to come under pressure. To address this issue, the ‘London Gold Pool’ was formed in 1961. The pool aimed to maintain the dollar peg to gold. However, as the US money supply grew, the gold reserves of the pool started to dwindle. By 1967, France withdrew from the pool and the pool collapsed by March 1968. It had become increasingly clear that the world monetary system was unstable and prime for a collapse.
Enter the SDR.
SDRs, or Special Drawing Rights, are a creation of the IMF. Like gold and dollars, they are a reserve asset to be held by central banks. Like all currencies of that time, SDRs were redeemable in gold. 1 SDR = 1 US$ = 0.888671g gold. To save the Bretton Woods system from collapse, the IMF allocated SDRs to its member states in proportion to their IMF quotas. Basically, that meant SDRs were ‘free money’ given by the IMF to member states in order to plug the holes in their balance sheets.
In 1971, the US declared that they are opting out of the Bretton Woods system and would no longer be redeeming their dollars in gold. Since then, the SDR was re-defined to represent a basket of currencies. Currently, this basket comprises of US$, British Pound, Euros and the Japanese Yen.
But effective October 1, 2016, they are going to be adding a new currency to the basket: the Chinese Renminbi, which gets a 10% weighting. Yes, the Chinese currency is now a part of this elite group. It shows how much China has progressed in the international space, to finally be recognised by the IMF as worthy of inclusion in its SDR. As a precursor to this move, SDR bonds were issued in China, for the first time in 35 years.
History of SDR issuances by IMF:
1970-72: SDR 9.3 billion
1979-81: SDR 12.1 billion
2009: SDR 182.7 billion
The three prior issuances of SDRs were all during periods of global monetary crisis. These SDRs were free money allocated to member countries. The issuance in 2009 dwarfs any previous issuance. Currently, the world sits on a debt pile which can never be repaid, 23% of world’s GDP comes from countries which have negative interest rates, and the IMF has moved to add the Chinese Renminbi to their SDR basket. Is this a sign that we can expect more SDR issuance ahead, particularly if we have a global debt crisis?