Reforming the international monetary system in the 1970s and 2000s: would an SDR substitution account have worked?

1. Reforming the international monetary system in the 1970s and 2000s: would an SDR substitution account have worked? Presentation by Robert N McCauley* Senior Adviser, Monetary and Economic Department To the joint Asian Development Bank/Centre for International Governance Innovation/Hong Kong Institute of Monetary Research conference on “The BRICS & Asia, Currency internationalisation, and international monetary reform”, Hong Kong, 10-11 December 2012 * Views expressed are those of the author and not necessarily the views of the BIS

2. Global crisis gives new evidence of dollar dominance… • Dollar shortage as non-US banks scramble for dollars • European banks need $ to fund US mortgage securities, loans to Asian borrowers • Dollar used in 90%+ of forward transactions • Huge premium for dollars in forward markets • Natural experiment in Polish & Hungarian forex markets: local currencies trade vs € for months then back to $: $ stable equilibrium • Unlimited Fed swaps to major central banks

3. …but also brings back a long-standing alternative: the SDR • Ted Truman convinced US Treasury to support issuance of SDR • Still SDR single-digit percentage of forex reserves • Gov Zhou embraces Triffin, SDR-based international monetary system • 2008 BIS Annual Report argues that an SDR based system would still required last-resort lending in constituent currencies • Truman proposes that IMF issue SDRs to Fed/ECB/… to fund swaps(!)

4. A single point of failure: a need for pluralism? • Kindleberger: leadership in global finance is stabilising • Political scientists dub this hegemony • Pluralism in international monetary system promises: • Joint control of growth of international liquidity • Fair sharing of rents • Protection against errors/ self-interest of hegemon

5. Varieties of Triffin • Original: US s-t debt growing with global econ undermines gold link. • Like 1st speculative attack model of Henderson & Salant/Krugman. • Ignored that Bank of England managed gold link with little gold. • Genberg & Swoboda argue: It’s the policies, stupid! • Generalised: Padoa-Schioppa: national policies unlikely to lead to global liquidity (however defined) growing at global optimum • Fiscal version: US government debt growing with global demand for reserves is inconsistent with US fiscal sustainability. • Ignores generation of safe assets w govt guarantees. • Ignores ability of banks and other sovereigns to produce safe assets in the dollar.

6. Hard to argue a global lack of liquidity (by any def)! • True, 2011 CGFS report uses “shortage” twice as much as “excess”. • But see Caruana speech to SEACEN governors in Ulaanbator. • Central bank balance sheets swollen; over ½ of US Treas held by off’s. • Safe assets shrinking with downgrades but expanding w deficits and expansion of agency debt • So those seeking more pluralism may look to substitution-type remedies that lower dollar share without increasing global liquidity.

7. Downgrades take toll on government bond markets

8. International monetary reform • Recurring doubts about ability of US dollar to continue to serve as the primary global reserve currency • Exorbitant privilege: unbalanced adjustment • Relative size of US economy declining • Dollar exchange rate weakening • Size of US external liabilities rising • Vulnerability to ‘tipping point’: disruptive transition to multipolar or other dominant asset • 1960s, 1970s, 2000s: revival of old proposals: Kenen (2010), Bergsten (2007), Camdessus (2009), Landau (2009), Palais Royale Initiative (2011), Angloni et al (2011), Farhi et al (2011)

9. Reform plans • 1961-67: Special Drawing Right (SDR) • Composite valuation, right to borrow convertible currencies • Triumph of consensus over clarity • Not a big reserve asset (2.6% global reserves) • Strictly official sphere of exchange • Unit of account, store of value, not a means of exchange • How to make SDR more “useful” to allow it to take on the properties needed to be a reserve asset • New push: SDR “serves as the light in the tunnel for the reform of the international monetary system”: Zhou (2009)

10. Substitution Account 1974 • 1973-74: Part of C20 proposals • Exchange USD for SDR through a Substitution Account (at IMF) • US worried about return paid on dollars in the Account • Others want US to pay off its liabilities • William Dale (US): “Unless the proponents of the various schemes had some practical way of dealing with the problem of financial obligation on the part of the reserve centers [i.e. the United States], little progress could be made” • Overtaken by oil crisis

11. Substitution Account 1978 • IMF MD Witteveen proposes rich countries “deposit” dollars equivalent to a fresh allocation of SDR into an Account at the IMF (dollars to be invested in US Treasury coupon securities) • Prevent SDR allocation from increasing international liquidity in inflationary environment • Begin to replace dollar reserves with SDR reserves • Rejected by United States and Europe • US would have to borrow dollars to deposit • Could weaken confidence in dollar • Some view as too lenient on US – want US to pay off liabilities • Too small to make a difference

12. Lessons and unresolved issues of early versions • US support crucial to any scheme’s success, but US Treasury is ambivalent over setting up a reserve rival to the US dollar. • The appropriate return on SDR/USD liabilities/assets in the Account? • The need for the US to take on a substantial share of any burden of keeping a scheme’s assets as large as its liabilities. • The desire of the Europeans that the United States amortise its obligations, making the international monetary system symmetric. • Governance of IMF: since less developed countries seek an important voice in negotiations, need to look beyond G10 if IMF to be involved

13. Substitution Account MD de Larosiere proposal 1978-80 • Cautious response, no drive from Ministers March 1979 • US Treas Solomon: enhance use of SDR w/o hurting $ confidence • G5 deliberations (UK, DE, FR, US, JP) April-August 1979 • Legal obstacles, burden of adjustment and exchange risk • June 1979 Financial Secretary Nigel Lawson: “we should not waste valuable manpower on matters such as the IMF substitution account. Over the years I can recall no aspect of the financial scene where so much high-powered effort has been expended to so little return” • August 1979: IMF Exec Bd prolonged wrangling gives no positive advice to Ministers • October 1979: Ministers meeting Belgrade: $ crisis, no progress • April 1980: Abandoned

14. Obstacles by 1980 • Political – needs to pass national legislatures • No mechanism to ensure US pays off its liabilities (shift from central banks to IMF) • Rich countries would benefit most (constrains use of IMF resources) • Ensuring solvency • How set returns on SDR liabilities and $ assets • Burden sharing (US vs others) • Terms of liquidation • IMF simulations suggest possibility of substantial losses (up to 35% of capital)

15. Issues • Open economy Fisher hypothesis that higher yields offset depreciation did not hold: USD depreciation exceeds modest yield premium over SDR rates • Interest payable options: • Treasury bill rate • 20 year Treasury bond rate • Whitelaw: “Ultimately, the substitution account could be effectively guaranteed only if the US Government followed economic policies that tended to maintain the value of the dollar”: but fear that mechanism reduces discipline on US • US can’t undertake to guarantee the SDR value of the Account – so how is the risk shared? • US vs creditors (at least 50-50) • IMF – via gold reserves

16. SDR rate payable on SDR claims on Account US Treasury bill rate earned by dollar liabilities of Account

17. Majority view: US should pay higher of 20-year bond rate or Treasury bill rate

18. Burden sharing • Participants contribute callable capital • IMF pledges gold to support the value of the Account • 20-25 million ounces (out of total 32 million) to cover fund of SDR50 billion • 20% of value of Account • Equivalent to amount of gold sold to benefit less developed countries • Gold proposals contested • Would benefit rich countries, contravene IMF Articles • At what point is the decision on liquidation taken? • How long will unrealised losses be allowed to run?

19. Simulations • SDR50 million in deposits of dollars • Profits of 25 million ounces of gold • Optimistic timing: • mid-1980 start, Treasury bill rate paid on dollars • Historically more realistic • Mid-1981 start (need to gather the participants and enact legislation where required) • 20-year Treasury bond rate (would work)

21. Insolvent within 5 years and would not have recovered, even given rise in price of gold since 2008

23. Conclusions • Existing studies don’t take account of the complex reasons for failure in 1980 • These obstacles still persist (burden sharing, risk sharing, amortisation, politics of main beneficiaries) • Start date is critical to outcome (but hard to judge ex ante): our scenarios start with USD trough (more favourable) • Optimistic scenario that IMF gold was deployed is still not enough to ensure solvency unless US was convinced to pay 20-year bond yield (currently 2-5 yr bonds usually held as reserves) • Need to keep re-opening the Account to make an impact on distribution of reserves (SDR50bn cumulates to 5% reserves by 2010) but timing etc. complicated