Political Economy of SDR Substitution Account: A Critical Analysis

1. Conference on The BRICS & Asia, Currency Internationalization, and International Monetary Reform Hong Kong, 10-11 December 2012 Comment on “Reforming the international monetary system in the 1970s and 2000s: would an SDR substitution account have worked” by Robert McCauley and Catherine Schenk Dong HE (何東) Executive Director (Research), Hong Kong Monetary Authority Director, Hong Kong Institute for Monetary Research

2. What does the paper do? • An archive based account of the political economy of the SDR Substitution Account proposal • Simulations of the solvency of the Account using historical observations of SDR interest rates and US treasury yields of bills, notes and bonds • Present a somewhat “skeptical” view on the proposal, in contrast to Kenen, Bergsten, and others

3. A quibble • A more comprehensive simulation exercise would call for a stochastic approach, deriving a probability distribution of the solvency of the Account • A stochastic simulation would make issues such as the initial conditions (e.g., the start date of the Account) less a problem in assessing the feasibility/sustainability of the Account

4. Broader and more fundamental questions • What is the nature of reserve currency issuance? Does the “Triffin Dilemma” generally hold? • What does that tell about the future of the SDR as a global reserve asset? • In principle, what would make an SDR substitution account work?

5. The nature of reserve currency issuance • A reserve currency country plays the role of a bank to the rest of the world: it provides a liquidity service by issuing short-term liabilities that non-residents would use for international trade and investment • But to prevent this process from becoming a Ponzi scheme, it also needs to invest in other countries, perhaps in less liquid forms and with longer maturity, such as foreign direct investments • In other words, issuing reserve currency is a process of financial intermediation through the international balance sheet of the reserve currency country

6. The Triffin Dilemma • In its original and narrow sense, the Triffin Dilemma points to a potentially explosive path of reserve currency issuance: short-term liabilities of the reserve issuing country grows infinitely against the backing of a stagnant stock of gold. This would cause a run on the currency, particularly if the short-term liabilities were caused by current account deficits • A main problem with Triffin’s arguments was that he ignored other assets that the United States had on its international balance sheet, i.e. its claims against non-residents, which were making good returns to finance its short-term liabilities • In a broader perspective, the Triffin Dilemma points to an inherent conflict: domestic policy objectives of the major reserve currency country overrides its obligations to maintain global monetary and financial stability

7. Implications for the SDR? • The issuance of SDR, which has to be of a much larger scale than ever envisaged to be a meaningful global reserve asset, needs to be backed by yield-enhancing claims on the asset side of the balance sheet • The SDR issuance process needs to be a maturity transformation process • In other words, the SDR issuer has to become more like a bank or a credit union • It is thus not surprising that McCauley and Schenk find that “basing the Treasury’s dollar interest payments to the Substitution Account on the 20-year bond yield would have done wonders for the solvency of the scheme”

8. Would an SDR substitution account in principle work? • Yes, if such an account is managed actively and professionally as a mutual fund • The yield on the SDR liabilities may need to be contingent on the performance of the fund • But this would still serve the original purpose of the substitution account: a diversification from the risk of a persistent depreciation of the US dollar

9. End of discussion Thank you for your attention!