What are Special Drawing Rights?

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Purpose of Special Drawing Rights (SDR)

  • It serves as an IMF unit and various other international organizations.SDR allocation plays an important role in providing liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more and supplementing member countries with official reserves during crises.It was created to serve as a supplementary international reserve in the context of the Bretton Woods fixed exchange rateFixed Exchange RateA fixed exchange rate refers to an exchange rate regime where a country’s currency value will be tied with the value of another country’s currency or a major commodity.read more system.They can exchange it for freely usable currencies of IMF members.

Features

The following are the salient features: –

  • The SDRs are allocated based on the quota system held by the individual member country of the IMF.SDRs are created under a special drawing accountDrawing AccountA drawing account is a contra owner’s equity account used to record the withdrawals of cash or other assets made by an owner from the enterprise for its personal use during a fiscal year. It is temporary and closed by transferring the balance to an owner’s equity account at the end of the fiscal year.read more. The resources of the special drawing account are made under an agreement among the member countries as a percentage of quotas with the IMF.Member countries use SDRs to meet liquidity requirements through bank creditBank CreditBank credit is usually referred to as a loan given for business requirements or personal needs to its customers, with or without a guarantee or collateral, with an expectation of earning periodic interest on the loan amount. The principal amount is refunded at the end of loan tenure, duly agreed upon, and mentioned in the loan covenant.read more creation. It helps the countries supplement the banking system’s resources to meet the liquidity needs of the country.The balance of payment deficit of a participant country is removed using SDR.It serves as a store value rather than a medium of exchange.Central banks of a member country of the IMF hold SDRs as their reserves, key currencies, and gold.SDRs are created as reserves and used to settle international payments.It helps build confidence among members as it has been statutorily laid down.Member countries are obliged to accept drawing rights from members providing funds in exchange for an equal amount of convertible currency.

How Does it Work?

SDRs work voluntarily. One prescribed SDR holder and various fund members agree to buy and sell SDRs freely. This fund facilitates the transactions between the member countries that seek to sell or buy SDRs and makes a voluntary agreement in the market of SDRs. If there are no voluntary buyers of SDRs, the IMF can designate members with a robust balance of payment position that helps them freely use currency and exchange for SDR. It is called the designation mechanism, where one can use SDRs to obtain a fair amount of money. Generally, SDR allocation is based on the existing IMF quota of each country.

How to Calculate the Value of Special Drawing Rights?

The specific amount of each basket currency valued in U.S. dollars is added up. Then, the currency amount is calculated per the exchange rates quoted in the London market at everyday noontime. Hence, the value of SDR is determined daily and is based on the weight of each currency that is included in the SDR basket, such as USD – 41.73%, EURO – 30.93%, CHINESE RENMINBI – 10.92%, JAPANESE YEN – 8.33%, POUND STERLING – 8.09%. These weights determine the amount of each of the currencies included in the new SDR valuation basket since October 16.

Example

In Moldova, the higher authorities of the nation used their SDR allocation after the budget crisis in late 2009, which helped them clear the accumulated arrears of expenditures, deteriorating fiscal position, and reduce reliance on short-term domestic financing, which was turning out to be expensive for the country.

Why Is SDR Required?

Countries like China and Russia had urged the IMF to move away from the U.S. dollar-based system, thus providing the path for the SDRs to become the de facto reserve currency of the world. These countries have been aware of the fragile economic conditions of the U.S. Also, countries like China were forced to buy more U.S. treasury debtsDebtsDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more to keep their economy afloat. Hence, the special drawing rights system was implemented where countries like China and others could exchange the excess dollars with a basket of currencies. They would still end up with around 44% dollars. That becomes a better scenario than being fully dependent on the U.S. economy.

Benefits

  • Reduced Dependence on the U.S. – Entire world will no longer be dependent on the currency of the U.S. to trade with each other.Issues of Balance of Payment – Most of the balance of paymentBalance Of PaymentThe formula for Balance of Payment is a summation of the current account, the capital account, and the financial account balances. The term balance of payments refers to the recording of all payments and obligations pertaining to imports from foreign countries vis-à-vis all payments and obligations pertaining to exports to foreign countries. It is the accounting of all the financial inflows and outflows of a nation.read more will be resolved as the U.S. will lose its privilege and the world goes off the Dollar standards. The budget deficitBudget DeficitBudget Deficit is the shortage of revenue against the expenses. The budgetary deficit could be the sum of deficit from revenue and capital account. read more problems of countries with the U.S. get resolved.Stable System – Since commodities like gold, oil, and food grains will not be exclusively traded in dollars. The U.S. government will not exert undue pressure on their prices by increasing and decreasing the supply of dollars. The Weighted AverageWeighted AverageThe weighted average formula is simply summing up the products of each value with its respective weightage. Here, more significance is given to the weightage of the values rather than the variables themselves.read more of basket currencies makes the system more stable.

Limitations

  • No Gold Backing – Tangible commodityCommodityA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.read more like gold makes the currency more stable, but replacing dollars with SDR would replace one unstable system with another slightly less hazardous system.Money Supply Becomes an Administrative Decision – Since SDR does not have an open market, the money supply becomes an administrative decision that the IMF will take, whether expanded or contracted.Abstract Nature – SDRs are an abstract weighted average of multiple currencies. These are not currencies on their own. Hence, it becomes difficult to implement and manage at a microeconomicMicroeconomicMicroeconomics is a ‘bottom-up’ approach where patterns from everyday life are pieced together to correlate demand and supply.read more level.

This article is a guide to Special Drawing Rights. Here, we discuss the purpose, features, examples, and calculation of Special Drawing Rights with benefits, and limitations. You may learn more about financing from the following articles: –

  • Currency CrisisFunctional CurrencyCurrency MarketCurrency Peg