## _041310 — Bibliography (excerpt): Reserve accumulation, IMS tensions, and reserve asset diversification

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### I. Framing, objectives, and overview
- Purpose:
  - Present ideas for discussion (not formal policy proposals) to gauge perceptions of IMS imperfections and costs/benefits of solutions.
  - Emphasis on voluntary collaboration under the Articles of Agreement and members’ obligation to collaborate on international reserves policies, including the long-term objective of making the SDR the principal reserve asset (Articles VIII, section 7, and XXII).
- Outline (paper structure):
  - Section II: reasons for rapid reserve accumulation and implications for IMS stability.
  - Sections III–IV: remedies to attenuate reserve demand and diversify reserve supply (including globally issued reserve assets such as SDRs).
  - Section V: conclusions and possible next steps.
- Preview of ideas (implementation/intensity spectrum shown in Figure 1 of source): guidance on reserve adequacy; voluntary multilateral frameworks; guidance on reserve issuer/holder policies; monitoring capital flows; wider use of SDR; substitution account; mandatory COFER reporting; multilateral framework for capital flows; penalties for imbalances; SDR-based/global currency system.
- Timeframes signaled: Near-term, Medium-term, Long-term; potential resistance and operational considerations noted.

*Contributors acknowledged: R. Duttagupta, R. Goyal, P. Khandelwal, I. Mateos y Lago, A. Piris, N. Raman (SPR) and many substantive contributors across RES, MCM, FIN, LEG, STA; inputs from R. Cooper and comments from B. Eichengreen, D. Rodrik, and K. Rogoff.*

### II. Reserve accumulation — principal findings, magnitudes, and scenarios
- Rapid growth and concentration:
  - International reserve accumulation accelerated rapidly, reaching 13 percent of global GDP in 2009 — a threefold increase over ten years.
  - Reserves remained concentrated in U.S. dollars.
  - For most emerging markets, reserve coverage rose to high levels relative to traditional norms, reaching almost 10 months of imports and 475 percent of short-term external debt in 2008.
  - Emerging market holdings rose to 32 percent of their GDP (26 percent excluding China) at end-2009.
  - Twenty-seven of the top 40 reserve holders, accounting for over 90 percent of total reserve holdings, recorded double-digit average growth in reserves over 1999-2008.
  - Holdings have become increasingly concentrated: over half the total held by only five countries.
  - Total reserve accumulation exceeded 10 percent of U.S. GDP in 2007; assuming two-thirds in dollar assets, such levels are unprecedented since World War II.
- Scenario/extrapolation:
  - If global reserves growth falls steadily to 8.5 percent per year by 2035 (from an average of 15.4 percent in 1999-2008), reserves as a proportion of U.S. GDP would still be rising at the end of the period, reaching 690 percent.
  - Shorter extrapolations indicate reserves approaching 120 and 200 percent of U.S. GDP in 2015 and 2020, respectively.
- Prospects and sustainability:
  - Absent changes in reserve policies, demand for reserves could reach levels insupportable by reserve issuers in the medium-to-long term.
  - Some mitigating changes may occur (e.g., greater use of sovereign wealth funds less invested in traditional reserve assets), but long-run pressures could continue as emerging markets deepen integration and seek more insurance.
- Systemic imperfections driving accumulation:
  - Identified imperfections include uncertainty about availability of international liquidity in a financial crisis; large and volatile capital flows; absence of automatic adjustment of global imbalances; absence of good substitutes to the U.S. dollar as a reserve asset (currency as a natural monopoly).

### III. Mechanisms behind accumulation and effects on economies and IMS stability
- Precautionary savings and capital flow volatility:
  - Global net private capital flows to emerging markets rose from $90 billion in 2002 to $600 billion in 2007.
  - Sample evidence: countries recorded a capital flow in excess of 3 percentage points of GDP in 7 of 18 years.
  - Booming inflows can fuel asset bubbles, poor resource allocation, balance sheet risks (especially with foreign currency lending), and currency appreciation pressures — prompting intervention and reserve accumulation.
- Ratchet effects and competitive accumulation:
  - Countries hold reserves to insure and to compare favorably with peers, creating ratchet effects and interdependent behavior that can raise costs of self-insurance.
- Absence of automatic adjustment:
  - Long-lived structural surpluses/deficits and persistent policy choices (e.g., undervalued exchange rates) can produce protracted reserve accumulation and complicate global adjustment.
- Negative economic and systemic impacts cited:
  - Domestic opportunity costs: foregone consumption and investment, likely high in many EMDCs.
  - Quasi-fiscal cost of sterilization: about 1.3 percent of EMDC’s GDP in 2009 (considering the 2000-2007 average EMBI spreads of 300 basis points over U.S. Treasuries and a term premium of 100 basis points (5-year versus 3-month Treasury yields)).
  - If only the term premium is included, the cost in 2009 falls to about 0.3 percent of EMDC GDP.
  - Aggregate deflationary spillovers if many countries pursue surpluses and the rest of the world is unwilling to incur deficits.
- Risks to reserve issuers and global stability:
  - Qualitative effects: significant official demand for government debt for reserve purposes can lower yields below market equilibrium, incentivize higher deficits, risk public debt sustainability, and undermine store-of-value characteristics.
  - Quantitative effects: lower benchmark yields may lead intermediaries to underprice risk, cause excessive credit creation, misallocated capital, and foster carry-trade/speculative positions.
- Evidence and magnitudes:
  - Warnock and Warnock (2006): Treasury purchases of 1 percent of U.S. GDP could lower yields on the 10-year benchmark by about 20 basis points.
  - Federal Reserve data: official purchases by central banks and SWFs averaged 2 percent of U.S. GDP per year since 2003.
  - McKinsey Global Institute (2009): impacts ranging from 30 to 200 basis points for 2006, with net foreign purchases of about 3 percent of GDP.
  - Reinhart and Rogoff (2009, 2010): repeated patterns of capital inflows, leverage, and crises; historically public debt levels above 90 percent of GDP have had an adverse impact on growth.

### IV. Role of the U.S. dollar and concentration risks
- Dollar functions and advantages:
  - Unit of account, medium of exchange, anchor for monetary regimes, store of value; deep U.S. Treasury market; large official holdings reinforce liquidity; depth of U.S. capital markets reduces diversification and portfolio management costs.
- Negative impacts of concentration:
  - Opportunity costs for accumulating countries; potential systemic deflationary effect; potential undermining of store-of-value via debt sustainability concerns and depressed interest rates fueling excessive risk-taking.
  - Concentration in a few currencies exposes the global system to shocks in reserve-issuing economies.
- Alternative views:
  - Arguments that U.S. deficits and reserve accumulation need not be connected; U.S. intermediation role might allow earning more on foreign investments than it pays on debts.
  - Caveats: these views do not directly address reserve asset quality amid fiscal sustainability concerns; growing official purchases relative to issuance suggest possible effects on Treasury yields.

### V. Mitigating reserve demand — three routes and operational measures
- Three broad routes to attenuate global reserve accumulation:
  - Agree on an “adequate” level of reserves for precautionary purposes.
  - Tackle volatility in capital flows (underlying precautionary demand).
  - Reduce accumulation of non-precautionary reserves (policy-induced surpluses).
- Monitoring and data improvements:
  - National authorities should provide the Fund data on cross-border exposures by country and institution; Fund could consolidate with balance-sheet exposures of large complex global financial institutions.
  - Requirement: high frequency (at least monthly) data on gross capital flows with “from whom to whom” information.
  - Current limitations: about 70 countries provide IMF portfolio investment data but as bilateral positions at annual frequency only; BIS bilateral bank exposures cover positions only.
  - Cost-management: expand coverage gradually, prioritize those dozen or so countries accounting for bulk of global capital flows, on a voluntary basis; Fund to set a common reporting framework and provide technical assistance.
  - Voluntary balance-sheet transparency: members could provide balance sheet data of large financial institutions key to global flows.
- Multilateral framework for capital flows (proposed elements):
  - Establish basic dos and don’ts for measures to dampen excessive flows and avoid adverse spillovers.
  - Provide a global process to identify when capital controls may be appropriate (e.g., when volatility is triggered by global monetary easing).
  - Provide a toolkit of options drawing on cross-country experience (see Ostry and others (2010) for discussion).
  - Encourage procyclical capital charges tied to global cycles and voluntary commitments by large financial institutions to maintain business in recipient economies during liquidity squeezes.
  - Consider consistency issues with existing arrangements (GATS, OECD Code, UE law, bilateral agreements).

### VI. Reducing non-precautionary accumulation — concerted approaches and penalties
- Concerted approach (voluntary framework):
  - Multilateral understandings for policy adjustments (e.g., systemic countries limit foreign exchange intervention; reserve issuers adopt macro frameworks like medium-term fiscal rules).
  - Potential quid pro quo: steps to strengthen the global reserve system (e.g., develop a systemic role for the SDR).
  - Implementation challenges: credible ex post accountability; gradual process preferable to big-bang.
- Penalties and automatic measures:
  - Proposals: reserve requirement on “excess” reserves or automatic tax on persistent current account imbalances beyond thresholds; tax base could be global GDP; proceeds to finance a global stability pool.
  - Legal constraint: amendments to the Articles would be required for implementation under the Fund.
  - Political economy: high pre-announcement and transition requirements; historical precedent of rejection (Committee of Twenty, 1974).
  - Caveats: case-by-case assessments and room for judgment may blunt effectiveness; automatic penalties distant from Fund’s cooperative culture and unlikely to attract support.

### VII. Diversifying the supply of reserve assets — rationale, modalities, and the SDR
- Rationale:
  - Supply-side solutions can meet reserve demand without the negative externalities of concentration; diversification reduces exposure to single-country risks and may strengthen policy incentives.
  - Natural monopoly of money implies diversification may require active coordination.
- Options considered:
  - Encourage diversification across existing currencies (multi-polar system).
  - Promote supranational reserve assets (SDR-based system or more ambitious global currency/bancor).
- Multi-polar system — scope and caveats:
  - Multiple currencies could serve as broad substitutes; transition could be long and uncertain.
  - Potential benefits: discipline reserve issuers via substitutability.
  - Downsides: lower network externalities, transaction costs, potential for greater exchange-rate volatility among reserve currencies; need for smooth, transparent management and coordination among issuers.
- SDR as a complement or endpoint:
  - SDR basics: created in 1969; value based on a basket of four currencies (U.S. dollar, euro, yen, pound); not itself a currency; usage requires conversion to freely usable currencies.
  - Advantages of SDR-based system:
    - Stability via basket diversification; scale economies; financial integration through SDR-denominated instruments; alignment of global monetary conditions; potential automaticity in adjustment if surplus countries peg to SDR basket.
  - Hurdles:
    - Low historical allocations: only SDR 21.4 billion allocated until mid-2009; subsequent SDR 182.6 billion allocations brought total stock to about 4 percent of total reserves.
    - Usage essentially restricted to official sector; restrictive allocation and usage rules; lack of deep and liquid markets; need to convert SDRs for most payments.
  - Collaboration needed: official sector promotion could increase private sector attractiveness; Supplement 1, section IV discusses collaborative areas.

### VIII. SDR allocation and instrument design options (numeric proposals preserved)
- Allocation options (text preserved verbatim):
  - Large and regular allocations, perhaps on the order of $200 billion annually (about half of the estimated annual increase in precautionary reserves, see Supplement 1, section IV) for some years:
    - During periods of strong demand or increased inflation risk, there could be either cancellation or no allocations.
    - Sterilization by central banks of allocations spent could neutralize impact on inflation.
    - Such allocations would not require a change in the Articles if they meet the required considerations governing allocations.
    - Alternatively, large and regular SDR allocations could be held in escrow with the SDR Department, for use in the event of exogenous shocks—introducing greater automaticity and predictability in decision-making and the use of SDRs. This would require an amendment of the Articles.
  - Modest allocations (say, $25 billion annually or up to 10 percent of quota as suggested by Clark and Polak 2004), though this would slow the move to an SDR-based system.
  - Targeted periodic allocations to a subset of members that are accumulating reserves for precautionary purposes, perhaps as part of a quid pro quo on reducing national currency-based reserve accumulation. This would require an amendment to the Articles.
  - Given the unconditional nature of SDRs, ensuring that countries in fragile debt dynamics do not overspend may be necessary, e.g., via a reconstitution requirement.
  - The 85 percent majority of the total voting power of the Board of Governors sets a high threshold for both allocations and cancellation and, therefore, makes both more difficult to achieve. Moving to a lower threshold, say 70 percent, while maintaining economic rationale for allocations, would make these decisions easier, and would symmetrically make cancellation easier.
  - To support the liquidity of these SDRs, the markets underpinning the voluntary exchange of SDRs would need to be deepened. A reconstitution requirement could support this objective as well.
- SDR-denominated issuance and market creation:
  - Substitution account: IMF-operated off-market mechanism for members to exchange foreign currency reserve assets for SDR-denominated claims; would require burden-sharing to cover foreign exchange risk.
  - IFI borrowing: more IMF SDR-denominated note purchase agreements and other IFI SDR-denominated debt (may require Articles amendment if large scale and de-linked from liquidity needs).
  - Government borrowing: governments issuing multi-currency debt could issue SDR-denominated bonds to consolidate market instruments and help build yield curves.
- Invoicing, pegging, and settlement:
  - Promote invoicing of trade and finance in SDRs (commodities like oil suggested as starting points).
  - Develop clearance systems in SDR-denominated instruments, noting settlement may still need to occur in a constituent currency.
  - Pegging to the SDR could increase demand for SDR-denominated instruments.

### IX. Substitution account and EM pooled assets (design highlights)
- EM assets as substitutes:
  - Pooling of EM sovereign debt into a securitized composite asset held as reserve assets; IMF-guaranteed liquidity via a trust fund during crises.
  - Repo window: Fund could lend to solvent countries against high-quality EM assets as collateral, on temporary basis and at a penalty rate (Articles consistency issues noted).
  - Design issues: qualification of claims as claims on non-residents; limits by country relative to pool; ceilings on holdings; pricing and exchange rate implications; moral hazard and membership criteria; safeguard issues for the Fund.
- Substitution Account (Box IV.3) — features and risks:
  - Off-market mechanism to exchange reserves for SDR claims, increasing SDR-denominated claims without market sales.
  - Exchange guarantee design options, including voluntary participation, quota-based loss distribution, premiums based on forward premia and volatility, and Fund-administered arrangements.
  - Risks: perverse incentives to accumulate more reserves; need for quid pro quo incentives to stem further accumulation.
  - Illustrative cost estimates: Kenen (2010) suggests limited global budgetary implications of a hypothetical substitution account established in the early 1980s — zero cost in the actual historical baseline and an upper bound of 0.3 percent of U.S. GDP annually during 1995-2008 under adverse scenarios.

### X. From SDR to a sui generis global currency (bancor) — ambitions, modalities, and caveats
- Limitations of the SDR: remains “inside money,” needs conversion, and its value remains linked to major component economies.
- Bancor concept:
  - A global currency used as “outside money” that circulates as a medium of exchange.
  - Adoption options: fiat common currency (like the euro) or parallel currency circulating alongside national currencies.
- Potential benefits of a bancor issued by a global central bank:
  - Nominal anchor: stable store of value reducing traded goods price variability related to exchange rates.
  - Global risk-free asset: bancor-denominated sovereign debt of highest-rated issuer could serve as a global risk-free asset less tied to largest economies’ circumstances.
  - Lender of last resort: global central bank could provide systemic liquidity more automatically.
  - Adjustment: adoption could make current account imbalances reflect structural rather than monetary considerations; parallel dominance could yield more symmetric automatic adjustment.
- Preconditions and challenges:
  - Significant political and institutional hurdles; adoption could limit monetary independence and require alternative adjustment and fiscal cooperation mechanisms.
  - Governance arrangements would need accountability, independence, and flexibility to accommodate diverse members.

### XI. Practical Fund roles and operational proposals
- Possible Fund actions to encourage orderly diversification:
  - Encourage gradual adjustment of currency composition and discourage active management that could cause large swings.
  - Require reporting of reserve composition to the Fund (possibly confidentially) and reserve holders’ benchmarks for currency composition.
    - Current COFER coverage: about two-thirds of total global reserves reported voluntarily.
  - Use reported information to advise on pace of diversification and maintain stability during transitions.
  - Engage with potential major reserve issuers to remove obstacles to broader use of their currencies.
  - Consider mechanisms to facilitate use of emerging market assets to draw liquidity and attenuate demand for hard-currency reserves.

### XII. Precautionary adequacy and debate over magnitudes
- Difficulty distinguishing precautionary from non-precautionary demand; two basic sources of self-insurance: importing capital and running current account surpluses.
- Share of global reserves that is precautionary:
  - By some estimates (Obstfeld et al., 2008), precautionary reserves account for between half and two-thirds of the total.

### XIII. Conclusion and issues for director-level discussion
- Overall assessment:
  - The global crisis of 2008/09 has not jeopardized international monetary stability, but the IMS has serious imperfections that feed reserves accumulation and reserves creation that are ultimately unsustainable.
  - Whether the IMS is stable will depend on policies of main economies.
  - Many reform avenues identified could reduce demand for international reserves and diversify composition, but most require complex international collaboration and are long-horizon efforts.
- Key questions for Directors:
  - Are there long-term threats to international monetary stability in recent reserve accumulation patterns (level and composition), and is collaboration worth undertaking?
  - Which areas for collaboration are most likely to be productive: reserve adequacy, capital flows volatility, global adjustment mechanism, diversifying national reserve assets, global reserve assets?
  - For high-priority areas, what are Directors’ reactions to the specific ideas outlined?
- Process note: Directors’ answers will help shape future work agenda; IMFC requested a report by Fall 2010.

*Source: IMF staff paper (excerpt) — content unit _041310.*

### Bibliography ...........................................................................................................

### Bibliography

### I. Introduction — framing and objectives
- Issue: Last comprehensive IMS reform discussion was nearly four decades ago; recent repeated and costly international financial crises make reviewing the IMS timely.
- Tension highlighted: unprecedented build-up in global current account imbalances and volatile cross-border capital flows, sharp build-up of international reserves, and concentration of reserves in a few reserve currencies facing fiscal and financial stability challenges.
- Paper perspective: Views IMS problems through tension between high reserve demand and narrow reserve supply; touches on exchange rate arrangements, capital flows, and the global adjustment process.
- Scope for change: Emphasizes voluntary collaboration under the Articles of Agreement and members’ obligation to collaborate on international reserves policies, including the long-term objective of making the SDR the principal reserve asset (Articles VIII, section 7, and XXII).
- Objective: Present ideas for discussion (not formal policy proposals) to gauge members’ perceptions of imperfections in the IMS and costs/benefits of solutions.
- Outline: 
  - Section II: reasons for rapid reserve accumulation and implications for IMS stability.
  - Sections III–IV: remedies to attenuate reserve demand and diversify reserve supply (including globally issued reserve assets such as SDRs).
  - Section V: conclusions and possible next steps.

*Key implementation/intensity figure previewed in Figure 1:*
- Ideas include guidance on reserve adequacy, voluntary multilateral frameworks, guidance on reserve issuer/holder policies, monitoring capital flows, wider use of SDR, substitution account, mandatory COFER reporting, multilateral framework for capital flows, penalties for imbalances, and an SDR-based/global currency system.
- Timeframes indicated: Near-term, Medium-term, Long-term for implementation; potential resistance and operational considerations noted.

*Contributors acknowledged:* R. Duttagupta, R. Goyal, P. Khandelwal, I. Mateos y Lago, A. Piris, N. Raman (SPR) and many substantive contributors across RES, MCM, FIN, LEG, STA; inputs from R. Cooper and comments from B. Eichengreen, D. Rodrik, and K. Rogoff.

### II. Reserve accumulation: causes and effects — principal findings
- Rapid reserves growth:
  - International reserve accumulation accelerated rapidly, reaching 13 percent of global GDP in 2009 — a threefold increase over ten years.
  - Reserves remained concentrated in U.S. dollars.
  - For most emerging markets, reserve coverage rose to high levels relative to traditional norms, reaching almost 10 months of imports and 475 percent of short-term external debt in 2008.
  - Pace of reserve accumulation showed signs of recovery after the crisis, reflecting GDP, trade, and financial flows recovery; pace might accelerate with further trade and financial openness.
  - Evidence suggests higher reserves helped reduce the crisis impact on growth in emerging markets, with declining benefits as reserve coverage increases.
- Prospects and sustainability:
  - Absent changes in reserve policies, extrapolations suggest demand for reserves would reach levels insupportable by reserve issuers in the medium-to-long term.
  - Some mitigating policy changes may occur (e.g., greater use of sovereign wealth funds less invested in traditional reserve assets), but long-run pressures could continue as emerging markets deepen integration and seek more insurance.
- Systemic imperfections driving accumulation:
  - Identified imperfections include:
    - Uncertainty about availability of international liquidity in a financial crisis.
    - Large and volatile capital flows.
    - Absence of automatic adjustment of global imbalances.
    - Absence of good substitutes to the U.S. dollar as a reserve asset (currency as a natural monopoly).

### Box II.1 — Reserve accumulation 2000–2010 and beyond (aggregate statistics and scenarios)
- Empirical snapshots:
  - At end-2009, reserves rose to 13 percent of global GDP, doubling from 2000 levels, and over 50 percent of total imports of goods and services.
  - Emerging market holdings rose to 32 percent of their GDP (26 percent excluding China).
  - Twenty-seven of the top 40 reserve holders, accounting for over 90 percent of total reserve holdings, recorded double-digit average growth in reserves over 1999-2008.
  - Holdings have become increasingly concentrated: over half the total held by only five countries.
  - Total reserve accumulation exceeded 10 percent of U.S. GDP in 2007; assuming two-thirds in dollar assets, such levels are unprecedented since World War II.
- Scenario/extrapolation:
  - Assuming reserve accumulation declines as emerging markets “mature” (global reserves growth falls steadily to 8.5 percent per year by 2035, from an average of 15.4 percent in 1999-2008), reserves as a proportion of U.S. GDP would still be rising at the end of the period, reaching 690 percent.
  - Shorter extrapolations indicate reserves approaching 120 and 200 percent of U.S. GDP in 2015 and 2020, respectively — suggesting demand may be hard to meet absent policy changes.
- Data caveats: Excludes substantial foreign assets of official sector not recorded as reserves (e.g., SWFs) that are often invested in liquid, dollar-denominated instruments.

### A. Symptom of imperfections in the system — mechanisms and dynamics
- Precautionary savings linked to volatile capital flows:
  - Global net private capital flows to emerging markets rose from $90 billion in 2002 to $600 billion in 2007.
  - Many emerging markets have limited financial intermediation capacity relative to potential inflows.
  - Emerging markets frequently face “floods” and “sudden stops”; in the sample, countries recorded a capital flow in excess of 3 percentage points of GDP in 7 of 18 years.
  - Booming inflows can fuel asset bubbles, poor resource allocation, and balance sheet risks (especially with foreign currency lending), and can generate currency appreciation pressures — prompting intervention and reserve accumulation.
- Ratchet effects and competitive accumulation:
  - Countries may hold reserves not only to insure against their own risks (e.g., cover short-term external debt) but also to compare favorably with peers in competition for capital, creating a ratchet effect.
  - Perceived links between reserve declines and increased crisis probability can lead countries to maintain substantially larger stocks than traditional metrics suggest.
  - Such interdependent behavior can raise the cost and effort required to maintain self-insurance.
- Absence of automatic adjustment:
  - Some current account surpluses/deficits reflect long-run structural factors (demography, productivity, resource endowments) and are not disequilibria.
  - Policy choices (e.g., maintaining undervalued exchange rates) can persistently postpone adjustment and produce reserve accumulation as a by-product.
  - If reserve-issuing countries are willing to incur debt to purchase imports, export-led growth with persistent surpluses remains feasible, complicating global adjustment as surplus economies grow.

*Source: _041310 - Bibliography (excerpt of IMF paper).*

### 12.       What else is there? The share of the U.S. dollar in global reserve assets far exceeds

### What else is there? The share of the U.S. dollar in global reserve assets far exceeds

### Role of the U.S. dollar as international cash
- The dollar acts across the world as a unit of account and medium of exchange for cross-border trade and financial transactions, debt securities, commodity pricing, an anchor for monetary regimes, and as a store of value for savers.
- Chief advantages supporting dollar dominance:
  - Asset market liquidity: U.S. Treasury market volumes far outstrip those of other reserve currencies such as the yen and euro.
  - Large official holdings and transactions in U.S. assets reinforce their liquidity, a key desirable feature of reserves.
  - Depth of U.S. capital markets offering a large variety of products and high volumes of trading can reduce diversification and portfolio management costs.

### Negative impact of large reserve accumulation
- General risks:
  - Large reserve accumulation has significant opportunity costs for accumulating countries and, in aggregate, may have a systemic deflationary impact.
  - Over time, it may undermine the quality of the store of value represented by reserve assets (through debt sustainability concerns) and, by depressing interest rates, foster excessive risk-taking and volatile capital flows.
  - Concentration of accumulation in a few currencies exposes the entire system to shocks arising in the reserve issuing economies.

### Costs (domestic and global)
- Domestic costs to reserve-accumulating countries:
  - Opportunity costs in terms of foregone consumption and investment, likely high in many EMDCs with high returns to capital and many unsatisfied social needs.
  - Quasi-fiscal deficit from sterilizing reserve accumulation when financed with higher-yielding debt—about 1.3 percent of EMDC’s GDP in 2009 (considering the 2000-2007 average EMBI spreads of 300 basis points over U.S. Treasuries and a term premium of 100 basis points (5-year versus 3-month Treasury yields)).
  - If only the term premium is included, the cost in 2009 falls to about 0.3 percent of EMDC GDP.
  - Valuation changes when an accumulator’s currency appreciates against reserve currencies create accounting costs if realized through reserve sales (but are not an economic cost unless realized).
- Global demand gap:
  - If reserve accumulation reflects many countries pursuing current account surpluses, an aggregate deflationary impact may emerge if the rest of the world is unwilling to incur deficits.
  - Potential consequences: protectionism and competitive devaluations; to date, reserve accumulation has reflected a mix of current account surpluses and capital inflows and the main reserve issuer acting as consumer of last resort has prevented a protracted deflationary bias so far.

### Reserves and IMS (International Monetary System) stability — potential sources of instability
- Two threats from large reserve accumulation relative to reserve issuers:
  - Qualitative effects:
    - Significant official demand for government debt for reserve purposes can lower yields below pure market equilibrium.
    - Lower yields may make marginal public projects appear more attractive, incentivizing higher deficits and debt, risking public debt sustainability and undermining the store-of-value characteristic of reserve assets.
    - These concerns could escalate to a rapid switch out of a specific reserve asset, producing large exchange rate and wealth effects and disruption to international payments and financial stability.
  - Quantitative effects:
    - Lower benchmark yields may lead financial intermediaries to underprice risk, potentially causing excessive credit creation, misallocated capital, and poor investment decisions.
    - Availability of cheap credit may encourage carry-trade investments and speculative positions funded by low-interest-rate reserve currencies.
    - If tighter monetary policy is not implemented, systemic effects described above may follow.
- Core country policy matters:
  - Policies in reserve-issuing countries (e.g., loose monetary policy) may be domestically warranted but can induce unwanted global demand effects.
  - The system is vulnerable to policy mistakes or private sector excesses in core economies.
  - A more inflation-prone reserve currency would affect exchange and interest rate volatility globally.
  - Financial regulation, supervision and practice in reserve-issuing countries will strongly influence how international financial flows are intermediated and the safety of the international financial system.

### Evidence and magnitudes cited
- Warnock and Warnock (2006): Treasury purchases of 1 percent of U.S. GDP could lower yields on the 10-year benchmark by about 20 basis points.
- Federal Reserve data (official purchases by central banks and SWFs): averaging 2 percent of U.S. GDP per year since 2003.
- McKinsey Global Institute (2009) summary table: impacts ranging from 30 to 200 basis points for 2006, with net foreign purchases of about 3 percent of GDP.
- Reinhart and Rogoff (2009): document repeated patterns of capital inflows, growth in leverage and risk-taking ending in crisis across advanced, emerging and less developed economies.
- Reinhart and Rogoff (2010): historically public debt levels above 90 percent of GDP have had an adverse impact on growth.

### Alternative views and resilience of the current IMS
- Arguments supporting current system resilience:
  - No necessary connection between U.S. deficits and reserve accumulation; demographic trends in the U.S. and persistent high savings in emerging markets could justify substantial U.S. external deficits.
  - U.S. intermediation role: earning more on foreign investments than it pays on debts to non-residents could raise capacity to carry large external debts.
  - Some question whether demand for reserves affects yields due to real factors determining aggregate global savings and arbitrage ensuring private demand adjusts if yields are depressed.
- Critical caveats:
  - These arguments do not directly address the quality of reserve assets amid fiscal sustainability concerns.
  - Alternatives to Treasury debt as reserve instruments are theoretically possible but difficult to identify without debasement risk, particularly given the role of highly rated mortgage-backed securities in the crisis.
  - Empirical evidence and the growing size of official purchases relative to issuance suggest a possible significant effect on Treasury yields.

### Exchange rate volatility and longer-run concerns
- Concern: long-run real exchange rate volatility between major currencies driven by financial flows may impose real-sector costs (uncertainty about costs and returns) sufficient to induce changes in the IMS.
- Historical observation: despite worries since the end of Bretton Woods, trade and cross-border investment have risen steadily, suggesting exchange rate volatility may not have significantly impeded growth.
- Some proposals in subsequent sections of the paper aim to address exchange rate volatility concerns.

### Mitigating the demand for reserves — road map and approaches
- Three routes considered to attenuate global reserve accumulation:
  - Agreeing on an “adequate” level of reserves for precautionary purposes.
  - Tackling directly the key factor underlying precautionary demand: volatility in capital flows.
  - Options to reduce accumulation of non-precautionary reserves.
- A separate important axis — provision of alternatives to self-insurance — is being considered in the context of the review of the Fund’s financing role.

### Precautionary reserves adequacy
- Distinguishing precautionary from non-precautionary demand is difficult: the two basic sources of self-insurance are importing capital and running current account surpluses.
- The share of global reserves that is precautionary is debated:
  - By some estimates, precautionary reserves account for between half and two-thirds of the total (e.g., Obstfeld et al., 2008, based on a model considering financial openness, access to foreign capital markets, potentially convertible domestic financial liabilities and exchange rate policies).

*Source: _041310 - 12.       What else is there? The share of the U.S. dollar in global reserve assets far exceeds*

### 25.      Appropriate levels. In order to underpin a concerted reduction in accumulation of

### 25.      Appropriate levels. In order to underpin a concerted reduction in accumulation of

### B. Reducing Underlying Volatility — Capital flow volatility and monitoring

- Finding: Managing capital flow volatility addresses a key motive for reserve accumulation; moderating demand for reserves alone treats a symptom.
- Evidence: Recent empirical work suggests financial globalization has likely increased volatility in developing countries with low financial sector development (see Dell’Ariccia and others, 2008).
- Policy options:
  - Closer monitoring of capital flows to identify potential instabilities.
  - Adoption of a multilateral framework for consideration of measures aimed at dampening capital flow volatility. The Fund’s role could range from purely advisory to jurisdiction over capital controls (the latter requiring an amendment of the Articles).
- Scope: A full discussion is beyond the current paper and will be further considered in coming months.

### Monitoring, data efforts, and operational measures

- Monitoring:
  - National authorities should collect and provide to the Fund data on cross border exposures by country and institution.
  - The Fund could consolidate this with balance-sheet exposures of large complex global financial institutions to map global linkages and risk concentrations.
  - With such mapping, authorities could assess what part of inflows are potentially unstable and would need reserve backing (example: FDI inflows would generally not).
  - Better mapping can reveal whether volatility episodes are driven by liquidity conditions in source countries (or global level) or by policies in destination countries, informing the efficacy of alternative management options.
- Data efforts:
  - Requirement: High frequency (at least monthly) data on gross capital flows with “from whom to whom” information.
  - Current limitations: Some 70 countries provide the IMF with data on portfolio investments, but these account for bilateral positions rather than flows and at annual frequency only; BIS data on bilateral bank exposures cover positions only.
  - Cost management: Potentially large resource costs could be addressed by expanding coverage gradually and prioritizing for those dozen or so countries that together account for the bulk of the global capital flows, on a voluntary basis.
  - Fund role: Set out a common framework for reporting such data (analogous to the national accounting framework). Given the public good nature, costs could be mutualized (e.g., Fund-provided technical assistance).
  - Balance sheet transparency: Members could voluntarily agree to provide balance sheet data of large financial institutions that are key conduits of global financial flows (see IMF 2010a and 2010b).
  - Recent steps: Coordinated efforts by the Fund and FSB in response to the G20’s call to address data gaps are a step in the right direction (see IMF, 2009, 2010c, and 2010e).

### A multilateral framework for managing capital flows

- Current gap: No comprehensive international framework covers all types of capital flows with global membership.
- Purpose and principles:
  - Recognize benefits of capital account liberalization under appropriate circumstances while acknowledging a role for measures (e.g., capital controls) to dampen excessive movement when necessary.
  - Emphasize that measures motivated by domestic considerations should help reduce global volatility and avoid adverse effects on others (example: comprehensive capital controls by a systemic country could increase volume and volatility of capital flows for others).
- Specific potential purposes of a framework:
  - (i) Establish basic dos and don’ts—e.g., ensure capital controls are not used in place of needed policy reforms for IMS stability (example: measures to allow global rebalancing of current account imbalances).
  - (ii) Provide a process for identification, at the global level, of when the use of capital controls may be appropriate for all exposed countries—e.g., when a sharp increase in capital flow volatility was triggered by an easing of global monetary conditions rather than by policy issues in destination countries.
  - (iii) Provide a toolkit of options (drawing on cross-country experience) that may be used to reduce capital flow volatility (see Ostry and others (2010) for discussion of capital controls at a country-level).
- Additional instruments and concerted actions:
  - Encourage adoption of procyclical capital charges based on global economic cycles rather than domestic cycles.
  - Elicit voluntary commitments from large financial institutions with deep macro-financial linkages in countries they invest in (e.g., subsidiaries of retail banks) to maintain business in recipients’ economies during a global liquidity squeeze.
- Considerations: Achieving consistency between a new multilateral framework and existing arrangements (e.g., GATS, OECD Code of Liberalization of Capital Movements, UE law, bilateral trade and investment protection agreements) would need to be considered and may be difficult.

### C. Reducing Non-Precautionary Accumulation of Reserves

- Backdrop:
  - Non-precautionary reserve accumulation is a consequence of other policy choices (e.g., export-led growth strategy) or structural differences (e.g., large public savings for intergenerational equity due to an oil endowment).
  - Structural accumulation should not be addressed by policy adjustments.
  - Accumulation via protracted one-sided intervention imposes a negative externality on the IMS and requires solutions to induce countries to internalize the cost.
  - Consensus on voluntary versus binding solutions is challenging because countries prioritize near-term national interests over IMS stability.
- Two approach types envisaged:
  - Concerted approach:
    - Multilateral framework of understandings among members to implement policy adjustments for effective IMS operation.
    - Examples: systemic countries might adopt over a pre-specified horizon flexible exchange rate regimes with limited or no foreign exchange intervention, or move away from pegs to national currencies; reserve issuers would adopt macro-economic policy frameworks (e.g., medium-term fiscal rules) to sustain credibility.
    - Potential quid pro quo: alongside exchange rate regime understandings, steps to strengthen the global reserve system (e.g., develop a systemic role for the SDR).
    - Implementation challenge: Credible ex post accountability for implementing understandings; a gradual process may be preferable to a big bang approach.
  - Penalties:
    - Proposals include a reserve requirement on “excess” reserves far above acceptable measures of reserve adequacy, or an automatic tax on persistent current account imbalances—surpluses or deficits—beyond a threshold.
    - Tax base could be defined in terms of global GDP to capture systemic impact; proceeds could finance a global stability pool for liquidity during unanticipated global crises.
    - Legal requirement: An amendment of the Articles would be required to establish such a system under the Fund.
    - Preconditions for support: Pre-announcement with sufficient transition time for implementation of measures to ameliorate underlying imbalances.
    - Political economy: Agreement would likely be considerably more challenging than ad hoc adjustments via multilateral consultations; historical precedent—global imbalance tax considered in 1974 by the Committee of Twenty did not gain support.
    - Caveats:
      - Case-by-case assessment appropriate given country fundamentals; room for judgment may prevent use of penalties as intended.
      - Automatic penalties are distant from the Fund’s cooperative culture and unlikely to attract support.
- Feasibility: Some reform options may require extraordinary political support and could take more than a lifetime; others may be unlikely absent a grand bargain involving deep changes to the supply of reserve assets.

### IV. Diversifying the Supply of Reserve Assets — Rationale and considerations

- Rationale:
  - Given limits on demand-side action, supply-side solutions can help meet reserve demand in a manner more conducive to IMS stability.
  - A more diversified allocation across available and new reserve assets would reduce exposure to risks from economic outturns and policies in a single country and may provide more stable stores of value by increasing reserve issuers’ incentives to pursue sound policies.
  - Global reserves are already diversified to some degree and further diversification is likely to continue gradually, but pace and degree may be insufficient if reserve accumulation continues apace.
  - A natural monopoly in the use of money implies diversification may require active coordination of all actors involved.
- Key question: Whether diversification should be encouraged among suitable existing currencies (and how) or sought via global reserve assets as complement or substitute.

### A. Scope and Feasibility of a Multi-Polar System

- Concept: A multi-polar system features several currencies operating as broad substitutes, perhaps alongside a set of secondary reserve currencies; could reflect multi-polarity in GDP weights.
- Uncertainties:
  - The process toward multi-polarity could be long; no guarantee the world will diversify significantly among pre-existing reserve currencies.
  - Demographic growth prospects may imply the U.S. has the greatest momentum over the longer run (see Cooper, 2008).
  - New reserve currencies could generate momentum for diversification.
- Potential benefits:
  - A diversified reserve system could discipline policies of all reserve issuers through enhanced substitutability of their assets.
- Downsides and open issues:
  - Lower network externalities: Transactional costs of converting among a few major currencies may be limited (example: direct costs of converting dollars into euros consist of a razor thin bid-ask spread).
  - Transaction costs: Managing exchange rate risk across multiple currencies could induce further polarization of the IMS into reserve currency zones aligned with trade patterns.
  - Volatility:
    - Volatility between major reserve currencies could impose substantial costs for trade and investment (see McKinsey Global Institute, 2009, Ghosh and others, 2010).
    - If reserve currencies become comparable with equally deep and liquid financial markets, hedging opportunities increase but short-term volatility may also rise.
    - A multi-currency system might exhibit greater long-run volatility, though not necessarily—central banks maintaining constant shares across reserve currencies could stabilize volatility in steady state.
  - Management: Smooth and transparent management of diversification is important to avoid large unwarranted swings.
  - Coordination: Volatility issues likely remain absent greater policy coordination between reserve issuers to manage exchange rates within acceptable ranges, or adoption of a common currency—both represent profound change.

### Box IV.1. Systemic Exchange Rate Arrangements — summary

- Problem: Significant degree of exchange rate volatility at high and low frequencies imposes economic costs.
- Conventional wisdom: Monetary policy independence and exchange rate flexibility confer benefits for adjusting to shocks and meeting domestic objectives, but exchange rate volatility often exceeds what is justified by real fundamentals.
- Proposed alternatives debated in literature:
  - Target zones for real effective exchange rates of main industrial countries (Williamson, 1987).
  - Monetary standard among major economies with fixed exchange rates around narrow bands (McKinnon, 1988).
  - Exchange rate convergence among major economies leading to a common currency for diversified industrialized economies (Cooper, 2006).
  - A global currency (Mundell, 2009).
- Role for the Fund:
  - Serve as a coordinating platform between key reserve issuers (e.g., through multilateral surveillance) to limit gyrations of exchange rates from fundamental values.
  - Give guidance to reserve issuers on reasonable equilibrium ranges of reserve currencies (e.g., implicit target zones) and maintain continuous dialogue to keep the system within those ranges.
- Political constraint: Such a role requires equal willingness of all reserve issuers to sacrifice monetary independence in the interest of lower IMS volatility, making it an ambitious long-run proposal.

*Source: Excerpt from IMF staff paper chapter on reserve accumulation, monitoring of capital flows, multilateral frameworks, and reserve asset diversification.*

### 38.      The Fund’s role. Should the membership deem it desirable to encourage the orderly

### 38.      The Fund’s role. Should the membership deem it desirable to encourage the orderly

### The Fund’s possible roles in guiding a diversified reserve system
- Encourage reserve holders to adjust the currency composition of reserves only gradually and discourage any “active” currency management that could potentially cause large swings between reserve currencies.
- Require all reserve holding members to report their reserve composition to the Fund (possibly confidentially) including information on reserve holder’s benchmark for the currency composition of reserves.
  - Currently, reporting of currency composition is voluntary for IMF members. The Fund’s Currency Composition of Official Foreign Exchange Reserves (COFER) database, which publishes aggregate information on the composition of total reserves, covers only about two-thirds of total global reserves.
- Using reported information, advise reserve holders on the pace of reserve diversification (if and when the latter express interest in adjusting the currency composition of their reserves) to maintain stability in the adjustment process, including during the transition phase to a balanced reserve system.
  - Example proposal referenced: Truman and Wong (2006) — two elements: (i) routine disclosure of the currency composition of official foreign exchange holdings; and (ii) a commitment by reserve holders to adjust gradually the actual currency composition of its reserves to any new benchmark for those holdings.
- Engage with potential major reserve issuers to help remove obstacles to broader use of their currencies, if the authorities so desire (Supplement 1, section III).
- Consider mechanisms to facilitate the use of emerging market assets to draw liquidity with greater certainty to attenuate their demand for hard-currency reserves (see Box IV.2).

### B. Supranational Reserve Assets — overview
- Consider greater role for the SDR as a complement to, or endpoint of, a multi-polar system.
- Consider an even more ambitious globally-issued currency distinct from the SDR that circulates in lieu of some national ones, or in parallel with them.
- Rationale: reduce tie of international monetary system to any individual economy; serve as “focal points” where scale economies operate.

### Special Drawing Rights (SDR) — concept for an SDR-based system
- The SDR is an international reserve asset created by the IMF in 1969 to supplement official reserves of member countries.
- For countries with a balance of payments need, the SDR represents an unconditional right to obtain foreign exchange or other reserve assets from other IMF members.
- The value of the SDR is based on a basket of four key international currencies (U.S. dollar, euro, yen, and pound).
- The SDR is not itself a currency; use in foreign exchange interventions and most payments requires conversion to one of the freely usable currencies of IMF members.
- A system centered on the SDR would maintain the SDR’s essential character as a reserve asset and unit of account without an actual currency role, while developing a broad market in SDR-denominated instruments in both the public and private sectors.

### Box IV.2 — EM Assets as Substitutes for Reserves?
- Goal: lower EMs’ demand for hard-currency reserves and carrying cost by enabling use of their own sovereign debt to draw liquidity through a pool or against a lender of last resort window.
- Pooling arrangement:
  - Sovereign debt issued by EMs pooled and securitized into a composite asset to be held by members of the pool as reserve assets.
  - Liquidity of the pool would be guaranteed by the IMF (administered through a trust fund that could be jointly funded by member contributions and own SDA resources), including during a crisis when liquidity from other sources dry up.
  - Would need to be sufficiently large, well-diversified, and provide reasonable assurance of liquidity based on pre-determined criteria to be a meaningful alternative to traditional reserves.
  - Important design issues: qualification of pool claims as claims on non-residents; limits on assets issued by a given country relative to pool size; ceilings on holdings based on quotas; pricing of the pooled asset and exchange rate implications; market openness; moral hazard and membership qualification criteria; safeguard issues for the Fund (e.g., Fund preferred creditor status).
- Repo window:
  - Fund could lend to solvent countries against collateral in the form of high quality EM assets, on a temporary basis and at a penalty rate.
  - Consistency issues with the Articles of Agreement (GRA lending against collateral currently not allowed if this fully substitutes for policy conditionality).
  - Introducing clear qualification requirements would make the instrument consistent with the Articles, provide certainty about availability of liquidity, and maintain the de facto preferred creditor status of the Fund.
  - Using an asset as collateral under a repo would not make it qualify as a reserve asset, but could reduce demand for traditional reserves by increasing certainty of access to liquidity.
- Note: See also IMF (2010d) for other ideas to alleviate emerging countries’ demand for reserves. (footnote 1/)

### Advantages of an SDR-based system
- Stability: SDR’s basket-based value diversifies currency and interest rate risks of constituent currencies, providing a more stable store of value and unit of account.
- Scale: SDR basket can provide a focal point around which a majority of international financial transactions could occur, benefiting from scale economies.
- Financial integration: Shifting demand toward SDR-denominated instruments could produce similar interest rates for countries with the same credit risk issuing SDR securities; increased substitutability could strengthen market discipline.
- Monetary conditions: Align global “monetary conditions” more with global developments than with conditions in any single economy, particularly if SDR basket is broadened.
- Adjustment: If surplus countries peg to the SDR basket rather than a national currency, some automaticity could be introduced into global adjustment as currencies of deficit countries could depreciate relative to others in the basket.

### Hurdles to SDR global monetary role
- Low historical allocations: only SDR 21.4 billion were allocated until mid-2009, and the SDR 182.6 billion allocations implemented thereafter only brought the total stock of SDRs to about 4 percent of total reserves.
- Usage essentially restricted to the official sector.
- Additional hurdles:
  - Potential resistance from reserve issuers who have no direct use for SDRs.
  - Restrictive allocation rules and complicated usage rules in the Articles of Agreement and Executive Board decisions.
  - Lack of deep and liquid markets.
  - Need to convert SDRs into a freely usable currency for most payments transactions.
  - Perception that greater volumes of SDRs could be used to thwart adjustment.

### Collaboration required to develop an SDR-based system
- Significant hurdles could be overcome if all or a significant subset of Fund member countries cooperated.
- Official sector promotion could increase private sector attractiveness of SDR-denominated instruments, creating a virtuous dynamic between public and private use.
- Key collaborative areas discussed in Supplement 1, section IV.

### SDR allocation options and design issues
- Increasing SDR’s role requires a significant increase in the stock of SDRs via substantial new allocations; existing rules make this difficult and may need amendment.
- Proposed allocation ideas (preserve numeric text exactly):
  - Large and regular allocations, perhaps on the order of $200 billion annually (about half of the estimated annual increase in precautionary reserves, see Supplement 1, section IV) for some years:
    - During periods of strong demand or increased inflation risk, there could be either cancellation or no allocations.
    - Sterilization by central banks of allocations spent could neutralize impact on inflation.
    - Such allocations would not require a change in the Articles if they meet the required considerations governing allocations.
    - Alternatively, large and regular SDR allocations could be held in escrow with the SDR Department, for use in the event of exogenous shocks—introducing greater automaticity and predictability in decision-making and the use of SDRs. This would require an amendment of the Articles.
  - Modest allocations (say, $25 billion annually or up to 10 percent of quota as suggested by Clark and Polak 2004), though this would slow the move to an SDR-based system.
  - Targeted periodic allocations to a subset of members that are accumulating reserves for precautionary purposes, perhaps as part of a quid pro quo on reducing national currency-based reserve accumulation. This would require an amendment to the Articles.
  - Given the unconditional nature of SDRs, ensuring that countries in fragile debt dynamics do not overspend may be necessary, e.g., via a reconstitution requirement.
  - The 85 percent majority of the total voting power of the Board of Governors sets a high threshold for both allocations and cancellation and, therefore, makes both more difficult to achieve. Moving to a lower threshold, say 70 percent, while maintaining economic rationale for allocations, would make these decisions easier, and would symmetrically make cancellation easier.
  - To support the liquidity of these SDRs, the markets underpinning the voluntary exchange of SDRs would need to be deepened. A reconstitution requirement could support this objective as well.

### SDR-denominated instruments — creation and issuance options
- Substitution account:
  - Creation of a substitution account could facilitate an increase in the stock of SDR-denominated instruments in one step.
  - Operated by the IMF, the account would be an off-market mechanism for IMF members to exchange foreign currency reserve assets for SDR-denominated claims.
  - A burden-sharing mechanism would be needed to cover the foreign exchange risk, which would likely be politically challenging (see Box IV.3).
- IFI borrowing:
  - Building on recent interest for IMF SDR-denominated note purchase agreements, more such borrowing agreements could be considered (albeit requiring an amendment of the Articles if such borrowing were to be done on a large scale, de-linked from the Fund’s liquidity needs, as quotas are the primary form of financing for the Fund and borrowing only supplements quota resources).
  - Other international financial institutions (IFIs) could also consider issuing SDR-denominated debt on a regular basis.
- Government borrowing:
  - Governments that issue debt in multiple foreign currencies may be “natural” issuers of SDR-denominated bonds.
  - Issuances could help consolidate instruments into a single market with easier-to-manage yield curves compared to multiple currency curves.
  - Demand for SDR assets may remain below demand for component currencies, causing a liquidity premium; extra initial costs for issuers could be seen as a subsidy to a nascent market for strengthening global financial architecture.

### Invoicing, pegging, and settlement in SDRs
- Promoting invoicing of international trade and finance in SDRs could enhance SDR role as a reserve asset.
- Invoicing commodities, such as oil, could be a useful and visible starting point because SDR prices are more stable than constituent currencies and commodities are used as hedges against dollar depreciation.
- Developing clearance systems in SDR-denominated instruments would facilitate private use, although settlement may need to be in one of the constituent currencies.
- Mechanisms to overcome inertia in using existing reserve currencies for invoicing and settlement would be needed.
  - One mechanism: pegging to the SDR. If countries peg exchange rates increasingly against the SDR, demand for SDR-denominated instruments would increase further.

### Box IV.3 — Substitution Account (summary)
- Background: Substitution account concept discussed in late 1970s when concerns about the dollar’s value emerged; not activated due to disagreements on cost sharing and improved dollar prospects.
- Potential benefits:
  - Large exchange of currently held reserves for SDR claims would increase SDR-denominated claims manifold.
  - If assets exchanged in same proportion as SDR basket, no accompanying exchange risk—account would increase SDR-denominated claims rather than diversify portfolios.
  - Off-market mechanism could facilitate diversification without triggering disorderly dollar decline from market sales.
  - Clear communication essential to limit adverse signals; could mitigate premia in U.S. long-term interest rates reflecting such risk.
- Risks:
  - Exchange guarantee could create perverse incentives to accumulate more reserves; guarantee would need to be accompanied by incentives to stem further accumulation as quid pro quo.
- Exchange guarantee design options:
  - Fund-administered account under Article V, Section 2(b) where the Fund may not bear financial exposure and members have voluntary exposure.
  - Participants could voluntarily agree to cover cost based on pre-specified mechanism such as quotas.
  - Alternative approaches: distribute losses in proportion to quotas across participants in a trust fund; charge account users an annual premium based on USD/SDR forward premium and exchange rate volatility with residual covered by participants.
  - Largest reserve holders and other systemic countries would need to participate for effectiveness.
- Cost:
  - Extent of loss could be limited if account mitigates risk of disorderly dollar decline.
  - Risk further reduced if it provides time for policy adjustments and rebalancing.
  - Illustrative calculations by Kenen (2010) point to limited global budgetary implications of a hypothetical substitution account established in the early 1980s — zero cost in the actual, historical baseline and an upper bound of 0.3 percent of U.S. GDP annually during 1995-2008 under adverse scenarios.

*Source: IMF chapter excerpt provided in content unit _041310 - 38. The Fund’s role. Should the membership deem it desirable to encourage the orderly*

### 47.      SDR basket. Both the composition and the rules underlying the choice of the SDR

### 47. SDR basket. Both the composition and the rules underlying the choice of the SDR

### Enhancing private sector use of SDR-denominated instruments
- The composition and the rules underlying the choice of the SDR basket matter for private sector use of SDR-denominated instruments.
- To enhance private sector use, the rules for the review of the basket—currently every five years by decision of the Executive Board—would need to be made transparent, simple, and automatic, so that changes are predictable.
- Removing uncertainty induced by judgmental or political factors would make the basket more akin to widely-used market indices (for example, the S&P 500), which provide real-time quotes for use in transactions and hedging despite periodic changes to the index.
- Components of the basket should continue to reflect their relative importance in the world’s trading and financial system, while maintaining stability and continuity (see Box IV.4).
- Inclusion of a non-convertible currency would open possibilities for gaining exposure to these currencies and could spur demand for SDR-denominated instruments, but would have downsides for those wanting to hold only convertible currencies; broader implications and costs would need careful consideration.
- The quinquennial review of the basket is scheduled later this year.

### Box IV.4. Composition of the SDR Basket
- Periodic reviews:
  - The Executive Board reviews the composition of the SDR basket every five years, although an earlier review could be contemplated in the event of major unforeseen developments in the international monetary system.
- Criteria:
  - The SDR basket comprises the four currencies issued by IMF members or monetary unions whose exports of goods and services during the previous five-years had the largest value and which have been determined by the Board to be freely usable.
  - At its 2000 review, the Board adopted a currency-based approach (in lieu of a member-based one, after the introduction of the euro), added to the selection criteria the Board’s determination of currencies as “freely usable” (i.e., as provided in Article XXX (f) “ a member’s currency that the Fund determines (i) is, in fact, widely used to make payments for international transactions, and (ii) is widely traded in the principal exchange markets”), and defined currency weights by combining the value of exports of goods and services of members or currency unions excluding intra-currency union trade and official reserves in the respective currencies held by other IMF members.
  - The Board adopted the same criteria at the 2005 review.
- Current basket:
  - The components and weights of the current basket are the U.S. dollar (44 percent), euro (34 percent), Japanese yen (11 percent), and pound sterling (11 percent).

### A sui generis Global Currency (From SDR to bancor)
- Limitation of the SDR:
  - The SDR is not a currency; SDR and SDR-denominated instruments need eventual conversion to a national currency for most payments or interventions, adding to cumbersome use.
  - The SDR’s value remains heavily linked to the conditions and performance of the major component countries.
- Bancor concept:
  - A more ambitious reform option is to develop, over time, a global currency—called, for example, bancor—that could be used as a medium of exchange—an “outside money” in contrast to the SDR which remains an “inside money”.
- Adoption options:
  - Common currency option: bancor adopted by fiat as a common currency (like the euro), yielding immediate widespread use and elimination of exchange rate volatility among adopters.
  - Parallel currency option: bancor circulates alongside national currencies and would need fiat adoption by at least some countries to develop an exchange market.
- Caveats and pre-conditions:
  - Without significant monetary instability or an injunction for use (e.g., payment of taxes), wide acceptance faces substantial barriers.
  - Adoption of a common currency could limit independent monetary policy, reducing adjustment scope when economies are not an optimal currency area; alternative adjustment mechanisms and fiscal discipline/cooperation mechanisms would be pre-conditions (for example, greater labor market flexibility).
  - Governance arrangements for the bancor-issuing institution would need to ensure accountability and independence and be flexible to accommodate differences among adopting members.
- Why bancor? Potential benefits if issued by a global central bank:
  - Nominal anchor:
    - As a stable store of value, bancor could serve as a global nominal anchor and reduce variability of traded goods prices related to exchange rate volatility.
    - By not being tied as tightly as the SDR to particular economies, bancor could provide greater monetary stability, especially since key central banks retain monetary control under an SDR-based system and their economies may face episodic stresses and volatility.
  - Risk-free asset:
    - Once liquid markets for bancor-denominated instruments exist and bancor-denominated transactions are at par with or exceed transactions in other currencies, bancor-denominated debt of the sovereign with the highest credit rating could serve as the global risk-free asset off of which all risky assets are priced.
    - The risk-free asset would be less tied to the credit ratings and inflation outlook of the largest economies and thus subject to less volatility and dependence on their specific circumstances than the SDR-based system.
  - Lender of last resort:
    - The global central bank could serve as a lender of last resort, providing systemic liquidity more automatically than at present (in the recent crisis such liquidity was provided mainly by the U.S. Federal Reserve).
  - Adjustment:
    - If bancor circulates as a common currency, current account imbalances among adopters would reflect structural rather than monetary considerations.
    - If bancor circulates as a parallel dominant currency replacing the U.S. dollar, current account imbalances could adjust more symmetrically and perhaps more automatically than in the current or SDR-based systems, as deficit currencies would be expected to depreciate against bancor.

### V. CONCLUSION AND ISSUES FOR DISCUSSION
- Overall assessment:
  - The global crisis of 2008/09 has not jeopardized international monetary stability, and the IMS is not on the verge of collapse.
  - The current system has serious imperfections that feed and facilitate policies of reserves accumulation and reserves creation that are ultimately unsustainable and expose the system to risks and shocks that a reformed system could minimize.
  - Whether the IMS is stable will depend on policies of the main economies.
  - The paper identifies reform avenues that could contribute to making the IMS more stable, reduce demand for international reserves, and diversify their composition; many reforms require new and complex international collaboration and are a long-haul effort.
- Key questions for Directors:
  - Are there long-term threats to international monetary stability in recent patterns of reserve accumulation (both their level and their composition), and would collaboration on these issues be worth undertaking?
  - Among the areas for collaboration identified in the paper (reserve adequacy, capital flows volatility, global adjustment mechanism, diversifying national reserve assets, global reserve assets), which are likely to be the most productive?
  - In the areas they deem as higher priority, what are Directors’ reactions to the specific ideas outlined in the paper?
- Process note:
  - Directors’ answers will help shape the future work agenda, bearing in mind the IMFC’s request for a report on these and other mandate-related questions by its Fall 2010 meeting.

*International Monetary Fund — content unit: _041310 - 47. SDR basket. Both the composition and the rules underlying the choice of the SDR*

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