Showing posts with label SDR. Show all posts
Showing posts with label SDR. Show all posts

Monday, September 23, 2019

A fifty-year history of Facebook's Libra

Last week, we finally got some information about what Libra's currency basket would look like.
If you haven't heard, Libra is a proposed global blockchain-based payments network. It is being spearheaded by Facebook along with a coalition of other companies including Uber, MasterCard, PayPal, and Visa.

The hook is that rather than going the conventional route and expressing monetary values using existing units-of-account like the dollar, yen, pound, or euro, the Libra network will rely on its own bespoke Libra unit-of-account as its "base language." Libra originally revealed in its whitepaper that the Libra unit would be defined as a basket, or cocktail, of other currencies. Now we know what that mix will likely look like.

Interestingly, the Libra isn't the world's first private unit-of-account. Back in the 1960s and 1970s, several financial institutions came up with their own bespoke units. I learnt about this strange and fascinating episode courtesy of a very readable paper by two economists, Joseph Aschheim and Y.S. Park.

As I gathered from the paper, the first private artificial currency unit was Luxembourg-based Kredietbank's European Accounting Unit (EUA). Originally devised in 1961 as 0.88867 grams of fine gold, the EUA was soon used to denominate a bond issue by SACOR, a Portuguese oil company. Over the next two decades, Aschheim & Park claim that around sixty or so bond issues would rely on Kredietbank's EUA as their accounting unit.

Between 1968 and 1971, the U.S. Treasury ceased to redeem dollars with gold. When the Smithsonian Agreement—a band-aid attempt to re-cement all currencies to the U.S. dollar—collapsed in 1973, the post WWII system of fixed currencies came to its final end. To help people cope with the sudden babble of floating currencies, several new private units-of-account joined Kreietbank's EUA.

N.M. Rothschild & Sons kicked things off in 1973 with its European Composite Unit, or Eurco. The Eurco was made up of nine currencies issued by members of the European Community, including Deutsche marks, French francs, and Danish kronor. According to Aschheim & Park, Rothshild developed the Eurco "to elicit investors' confidence" in long-term bonds, but as of 1976 only three bond issues had been denominated in Eurcos.

In 1974 Hambros Bank introduced the Arab Currency-Related Unit, or Arcru. The Arcru was comprised of twelve Arab currencies and designed to appeal to Arab investors flush with oil profits. The next year Credit Lyonnais created a bouquet of the ten currencies, both European and non-European, and dubbed it the International Financial Unit, or IFU. This was a far more broad-based unit than the Arcru or Eurco, the relative weights of the IFU's component currencies being based on each country's share of international trade.

Barclays Bank also got into the game in 1974 with the Barclays Unit, or the B-Unit. The B-Unit was made up of five currencies: the U.S. dollar, the British pound, the German mark, the French franc, and the Swiss franc. Aschheim & Park note that whereas the Arcru, IFU, and Eurco were primarily intended for denominating bonds, the B-Unit was designed to be used for making international payments.

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Which makes the B-Unit a direct predecessor of the Libra unit.

Look around you today, however, and not one of these private units-of-account listed below exists. Anyone want to pay me in B-Units? I didn't think so. I think this says something quite fundamental about the market's demand for artificial currency units. Businesses and consumers don't really like to use them.

Table from Aschheim & Park

If private artificial currency units have been failures, what about government-provided ones?

Take the International Monetary Fund's Special Drawing Right (SDR) basket, which has been in existence since 1970, almost fifty years. If there was a demand to make international payments using public artificial units of account, surely commercial banks would eventually have met that demand by implementing SDR-denominated payments systems. Indeed, Aschheim & Park speculate on the possibility in their 1976 paper. It's worth reading this section in full:
"International banks may soon be willing to accept deposits denominated in SDRs because a potential demand for SDR funds already exists, as manifested by recent SDR bond issues by the Swiss Aluminum Company, the Swedish Investment Bank, and Electricite de France. The process, indeed, is already under way. In July 1975 the Bank Keyser Ullmann in Geneva (a subsidiary of Keyser Ullmann of London) announced that it would henceforth accept demand and time deposits denominated in SDRs. These SDR deposits are to be convertible at any time into any currency at the SDR exchange rate applicable on that day. Similarly, in August 1975 the Chase Manhattan Bank in New York instituted a range of banking facilities in SDRs, including loans, deposits, and futures trading. As this process spreads and as more international transactions are denominated in SDRs, banks may begin to allow direct transfers between SDR accounts, internally and then between banks. In consequence, the SDR may be transformed from mere numeraire (international quasi-money) into an outright means of payment (full-fledged international money)."
Again, look around you today. How many banks let you open an SDR-denominated bank account and make SDR payments? None that I'm aware of. Maybe the IMF's SDR was never well designed, or maybe Barclays was too small to drive B-Unit adoption. Or more likely SDRs, B-Units, and the other artificial currency units mentioned in Aschheim & Parks paper are all monetary dead-ends. In pursuing the same path, Libra could be making a big mistake.

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What is it about artificial currency baskets that makes them non-starters? My first post about Libra delved into this question. Let me repeat my argument below to spare you the effort of clicking through.

In an alternative reality, let's imagine that Facebook only allows users to join and converse on its platform after having learnt Facebook's artificial language, Facebookish. English, French, Chinese, and all other languages are banned.

In this alternate reality, all Facebook users understand each other because each one is fluent in Facebookish. Comprehension is a great thing. But hardly any of us would be on Facebook to begin with. Who wants to go through the effort of learning a new language? Not me.

In the real world, Facebook has long since decided against the Facebookish approach. Instead, it supports a multitude of local languages—Arabic, Chinese, English, Hindi, and more. Sure, the drawback is that we can't always understand what other Facebook users are saying. But at least users don't have to go through the hurdle of learning new grammar and syntax. And Facebook has thrived as a result of this simple and obvious design choice.

The adoption of a Libra unit of account is the monetary equivalent of forcing users to learn Facebookish. Sure, at least with Libras we'll all be using the same currency units. But this ignores the costs we'd all have to incur as we learn a new monetary patois. From a very young age we all figure out how to "speak money". We speak in our local unit-of-account. As a Canadian, the Canadian dollar has always been the means by which I describe prices to people around me, and remember values, and engage in cost-benefit calculations. Facebook wants to force us all to learn a new monetary language, a Libra-based one. But in doing so it's setting a huge hurdle to adoption.

So I'll just repeat. No matter how skillfully it goes about designing Facebookish (or Libras), artificial languages and artificial units are dead-ends. They're utopian, and definitely not user-friendly. (Ok, I may have described it all better in my original post, so just head on over.)

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That being said, over the last few months I've been slowly warming up to Libra. Out of the millions of crypto projects that have come out over the last decade, it comes close to the Fedcoin vision I originally outlined on my blog back in 2014, and twice now for R3.

To begin with, a Libra token would be stable (unlike bitcoin) thanks to credible and strong issuers. Since it would be decentralized, the network would be resilient. And since a Libra is a token, and not an account, it should be relatively open for everyone to use. At the same time, David Marcus, the architect behind Libra, is making the right noises about financial privacy. (Whether his intentions are genuine or not, it's tough to say.)

From the Libra whitepaper

I think (and I could be wrong here) that there is a growing desire on the part of consumers for more financial privacy. Unfortunately, governments hew to a post-9/11 mindset that regards privacy as a pervasive threat. Facebook may be one of the only organizations with the financial heft to articulate consumers' desires for more privacy in a way that regulators can't ignore.

Having Facebook as financial privacy advocate is a fragile win, no? It would be too bad if Libra (and whatever level of financial privacy it promises to bring to mainstream consumers) never attains widespread usage because of a basic design flaw, one that obligates us all to adopt the monetary-equivalent of Facebookish

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If not an artificial currency basket, what should Facebook do? I think that most consumers who engage in cross-border transactions want to keep swimming in their domestic currencies up until the last minute. Only at the 'buy now' or 'send now' moment—i.e. when a purchase it to be consummated or funds transferred to a friend—do we want to leave the bubble of our home currency. Pre-accumulating some strange alien token, whether those be SDRs, B-Units, or Libra, just isn't on the table.

If it wants to stay customer friendly, Libra needs to design its network to allow for the flow of tokens denominated in state currencies (U.S. dollars, Chinese yuan, British pounds, Indonesian rupee). And then it needs to design a cheap, transparent, and easy way for these tokens to move from person to person. This is what PayPal does. It's also worked for Transferwise. Visa and MasterCard too. None  of these platforms have created their own curious units, PayPalios or TransferWise-units or Visa-oos. They've allowed customers to remain safely ensconced in their domestic currency bubbles until the final 'send now' moment.

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Putting aside my criticisms of Libra's decision to use an artificial currency unit, what do I think about its choice of basket?

I am left wondering what sort of process David Marcus and the folks at Facebook have used to generate the basket components. Potential Libra users will want to know ahead of time how they can expect a basket's components to be updated as time passes. After all, if their wealth is to be held on the platform, customers will wonder what is to prevent a sudden rewriting of the basket in a way that favors the network at their expense?

One important rule that everyone will want to know is what economic thresholds are being used to filter out or include various currencies. For instance, if the Korean won starts to become a popular international currency, at what point will Libra decide to include it in the basket? If so, would it boot out another currency to make way for the won, or keep it?

The current Libra components are definitely odd, and give no indication of what process the architects are using to populate the Libra basket. For instance, I'm not aware of any selection process or rule that would lead to the Singaporean dollar comprising 7% of what is supposed to be a "global currency." Don't get me wrong. I like Singapore. It punches above its weight. But Singapore doesn't account for 7% of world trade, or 7% of the world's population, or 7% of global anything.

Or why does the euro account for just 18% of the Libra basket while the U.S. makes up a mammoth-sized 50%? The European Union has twice the population of the U.S. and accounts for a far larger share of exports. And where is the Chinese yuan? Exiled for political reasons?

One wonders if the euro's small share has to do with the effect that Europe's negative interest rates might have on network profits. For each Libra it has issued, the consortium will have to keep a Libra's worth of assets in reserve. Far larger profits can be earned it it reduces the euro portion of the basket and increases the U.S. dollar portion. After all, that would mean more exposure to high-yielding U.S. dollar assets and less to negative-yielding European ones. But that's a terribly ad hoc way to construct a currency basket.

My last thought is this. If Libra has its heart set on choosing an artificial currency unit as the basis for its global currency, it should have probably just go with the IMF's SDR basket rather than brewing its own strange currency concoction.

The IMF's SDR basket (source)

Consider how exchange-traded funds which track an index outsource all of the decisions about index methodology and components to third-parties like Standard & Poors, MSCI, and FTSE. This makes the exchange-traded fund more credible. Using SDRs would pre-commit Libra to avoiding conflicts of interest and thorny politics, the IMF becoming the theater for determining the basket. One could find worse third-parties than the IMF.
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Tuesday, June 25, 2019

Esperanto, money's interval of certainty, and how this applies to Facebook's Libra


Facebook recently announced a new cryptocurrency, Libra. I had earlier speculated about what a Facebook cryptocurrency might look like here for Breakermag.

I think this is great news. MasterCard, Visa, and the various national banking systems (many of which are oligopolies) need more competition. With a big player like Facebook entering the market, prices should fall and service improve, making consumers better off.

The most interesting thing to me about Facebook's move into payments is that rather than indexing Libras to an existing unit of account, the system will be based on an entirely new unit of account. When you owe your friend 5 Libras, or ≋5, that will be different from owing her $5 or ¥5 or £5.  Here is what the white paper has to say:
"As the value of Libra is effectively linked to a basket of fiat currencies, from the point of view of any specific currency, there will be fluctuations in the value of Libra."
So Libra will not just be a new way to pay, but also a new monetary measurement. Given how Facebook describes it in the brief quotation provided, the Libra unit will be similar to other unit of account baskets like the IMF's special drawing right (SDR), the Asian Monetary Unit (AMU), or the European Currency Unit (ECU), the predecessor to the euro. Each of these units is a "cocktail" of other currency units.

Facebook's decision to build its payments network on top of a new unit of account is very ambitious, perhaps overly so. When fintechs or banks introduce new media of exchange or payments systems, they invariably piggy back off of the existing national units of account. For instance, when PayPal debuted in 2001, it didn't set up a new unit called PayPalios. It used the dollar (and for the other nations in which is is active, it used the local unit of account). M-Pesa didn't set up a new unit of account called Pesas. It indexed M-Pesa to the Kenyan shilling.

I couldn't find a good explanation for why Facebook wants to take its own route. But I suspect it might have something to do with the goal of providing a universal monetary unit, one that allows Facebook users around the globe to avoid all the hassles of exchange fluctuations and conversions.

Global monetary harmony an old dream. In the mid 1800s, a bunch of economists, including William Stanley Jevons, tried to get the world to adopt the French 5-franc coin as a universal coinage standard. Jevons pointed out that the world already had international copyright, extradition, maritime codes of signals, postal conventions—so why not international money too? He wrote of the "immense good" that would arise when people could understand all "statements of accounts, prices, and statistics." It would no longer be necessary to employ a skilled class of foreign exchange specialists to take on the "perplexing" task of converting from one money to the other.

But the plan to introduce international money never worked out. (I wrote about this episode for Bullionstar).

Global money like Libra might seem like a great idea. But ultimately, I suspect that the decision to introduce a new unit of account will prevent Libra from ever reaching its full potential. Units of account are a bit like languages. If you are an English speakers, not only do you communicate to everyone around you in English, but you also think in English. Likewise with the dollar or yen or pound or euro. If you live in France, you're used to describing prices and values to friends and family in euros. You also plan and conceptualize in terms of them.

It's hard to get people to voluntarily switch to another language or unit of account once they are locked into it. For instance, in the 1800s L.L. Zamenhof attempted to get the world to adopt Esperanto as a language in order to promote communication across borders. To help facilitate adoption, Zamenhof designed it to be easy to learn. But while around 2 million speak Esperanto, it never succeeded in becoming a real linguistic standard. The core problem is this: Why bother learning a new language, even an easy one, if everyone is using the existing language? 

Facebook's Libra project reminds me of Zamenhof's Esperanto project. Nigerians already talk and compute in naira, Canadians in dollars, Indonesians in rupiahs, and Russians in rubles. Why would any of us want to invest time and effort in learning a second language of prices?

Let me put it more concretely. I do most of my families grocery shopping. Which means I keep track of an evolving array of maybe 30 or 40 food prices in my head. When something is cheap relative to my memory of it, I will buy it—sometimes multiple versions of it. And when it is expensive, I avoid it. But this array is entirely made up of Canadian dollar prices. I don't want to have to re-memorize that full array of prices in Libra terms, or keep two arrays of prices in my head, a dollar one and a Libra one. I'm already fluent in the Canadian dollar ones.

Nor will retailers like Amazon or the local corner store relish the prospect of having to advertise prices in both the local unit of account and Libra, plus whatever unit Google and Netflix choose to impose on us. 

So Facebook is inflicting an inconvenience on its users by forcing us to adopt a new unit of account. To make for a better user experience, it should probably index the Libra payments network to the units of account that we're all used to. 

If not, here is what is likely to happen. We'll all continue to think and communicate in terms of local currency. But at the last-minute we will have to make a foreign exchange calculation in order to determine out how much of our Libra to pay at the check-out counter. To do this calculation, we'll have to use that moment's Libra-to-local currency exchange rate. This is already how bitcoin transactions occur, for instance.

But this means that Libra users will lose one of the greatest services provided by money: money's interval of certainty. This is one of society's best free lunches around. It emerges from a combination of two fact. First, most of us don't live in a Libra world in which we must make some sort of last-minute foreign exchange calculation before paying. Rather, we live in a world in which the instruments we hold in our wallet are indexed to the same unit of account in which shops set prices.

Monetary economists call this a wedding of the medium-of-exchange and unit-of-account functions of money. This fusion is really quite convenient. It means that we don't have to make constant foreign exchange conversions every time we pay for something. A bill with a dollar on it is equal to the dollars emblazoned on sticker prices.

Secondly, shops generally choose to keep sticker prices fixed for long periods of time. Even with the growth of Amazon and other online retailers, Alberto Cavallo (who co-founded the Billion Prices Project) finds that the average price in the U.S. has a duration of around 3.65 months between 2014-2017. So for example, an IKEA chair that is priced at $15 will probably have this same price for around 3.65 months. This is down from 6.48 month between 2008-10. But 3.65 months is still a pretty long time.

Why do businesses provide sticky pricing? In the early 1990s Alan Blinder asked businesses this very question. He found that the most common reason was the desire to avoid "antagonizing" customers or "causing them difficulties." Blinder's findings were similar to Arthur Okun's earlier explanation for sticky prices whereby business owners maintain an implicit contract, or invisible handshake, with customers. If buyers view a price increase as being unfair, they might take revenge on the retailer by looking for alternatives. (I explore these ideas more here).

Anyways, the combination of these two factors—sticky prices and a wedding of the unit of account and medium of exchange—provides all of us with an interval of certainty (or what I once called money's 'home advantage'). We know exactly how many items we can buy for the next few weeks or months using the banknotes in our wallet or funds in our account. And so we can make very precise spending plans. In an uncertain world, this sort of clarity is quite special.

Given Libra's current design, the interval of certainty disappears. Store keepers will still keep prices sticky in terms of the local unit of account, but Libra users do not benefit from this stickiness because Libras aren't indexed to the same unit as sticker prices are. Anyone who has ≋100 in their account won't know whether they can afford to buy a given item two weeks from now. But if they hold $100, they'll still have that certainty, since dollar prices are still sticky.

If money's interval of certainty is important, it is particularly important to the poor. The rich have plenty of savings that they can rely on to ride out price fluctuations. The fewer resources that a family has, the more it must carefully map out the next few day's of spending.  The combination of sticky prices and a wedding of the unit-of-account and medium-of-exchange affords a vital planning window to those who are just barely getting by.

This clashes with one of Libra's founding principles: to help the world's 1.7 billion unbanked. Here is David Marcus, Libra's project lead:

Most of the world's unbanked people are poor. But Libra won't be doing the poor much of a favor by choosing to void the interval of certainty that they rely on. If Facebook and David Marcus truly wants to help the unbanked, it seems to me that it would better to index Libras to the various local units of account.

I suppose there is an argument to be made that Libras could provide poor people in nations with bad currencies a haven of sorts. Better Libras than Venezuelan bolivars, right? But the nations with the world's largest unbanked populations—places like India, Nigeria, Mexico, Ethiopia, Bangladesh, and Indonesia—all have single digit inflation, or close to it. Extremely high inflation is really just a problem in a few outliers, like Zimbabwe and Venezuela.

Besides, providing those who endure high inflation with a better unit of account isn't the only way to help them. Offering locally-denominated Libras that offer a compensating high rate of interest would probably be more useful. Not only would these types of Libra offer inflation protection, but they would preserve the interval of certainty.

Thankfully, I suspect that Libra is very much a work-in-progress. The current whitepaper seems to give only a hint of what the project might become. If so, one of the changes I suspect Facebook will have to make if it wants to get traction is to link the Libra network to already-existing units of account. A new unit of account is just too Utopian.
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Thursday, February 9, 2017

To what extent can Trump trash the dollar?


Donald Trump doesn't like the strong dollar, but is there anything he can do about it?

Last month Donald Trump told the Wall Street Journal that American companies can’t compete "because our currency is too strong. And it’s killing us...” Trump's dislike of the strong dollar doesn't surprise me. I've known a few mercantilists over the years, and all of them have always been keen on trashing their home currency, the idea being that with a weaker currency domestic manufacturers will enjoy a shot to the arm. This in turn stems from the antiquated (and very wrong) idea that manufacturing is somehow the most important activity an economy can be engaged in.

Tweeting about one's desire for a weak dollar is one thing, but are there any actual levers Trump can pull on to affect the exchange rate?

U.S. exchange rate interventions are rare these days, with only two occurring in the last twenty years. In September 2000 U.S. monetary authorities intervened with other central banks to support the euro, and in March 2011 they bought yen after the earthquake that rocked Japan on March 11. The main concern of modern central bankers is their inflation target. To hit this target, interest rates have become the preferred tool. Unlike the gold standard or Bretton Woods era, the exchange rate has little role to play in this story, either as a target of monetary policy or as a tool.

Past efforts to fiddle with the dollar's exchange rate have typically been joint affairs taken on by the Federal Reserve and the Treasury. It makes sense to have the central bank as a partner because a central banker has the ability to create as much money as necessary in order to drive the exchange rate down. If Trump were to try to go it alone, he'd first have to go through the hoops of raising taxes or issuing bonds in order to get the requisite dollars to sell, this being a much weaker lever compared to the Fed's infinitely-powerful printing presses.

If Trump were to request that the Fed weaken the dollar, could Fed Chair Janet Yellen refuse to co-operate? The Fed could certainly dig in its heels. Anna Schwartz, channelling former Fed chairman Paul Volcker, notes that "the Treasury does not have authority to instruct the Federal Reserve to spend its own money on intervention and to take the attendant risks, and that the Treasury would be reluctant to intervene over strong objections of the Federal  Reserve." This Peterson Institute publication provides an actual example of heel-digging. In 1990, most of the members of the FOMC were against continued purchases of Deutschmark and yen by George Bush, with three members voting against raising warehousing limits (see below for a description of warehousing) from $10 billion to $15 billion. While their push back wasn't enough to carry the day (the warehousing ceiling was increased), presumably it indicates that the Fed has a means for resisting Treasury demands, if not always the guts. The Fed has at times been dragged along as an "unwillingly participating" in Treasury-initiated interventions because—as Michael Bordo, Anna Schwartz, and Owen Humpage put it—appearing not to cooperate would "raise market uncertainty and could sabotage the operation's chance for success."

Given these conflicting views about the hierarchy between Fed and Treasury, when push comes to shove I don't know who would win out in a conflict between the two institutions. What seems sure is that any effort by Trump to arm twist the Fed into weakening the dollar would be controversial. If the Fed were to get its way, expect to hear outrage about the trampling of democracy by an "inbred" technocracy of academic economists. On the other hand, if Trump were to get his way he would be denounced for threatening the Fed's ability to keep inflation in check. As Goodfriend and Broaddus put it in this paper, Fed participation in Treasury-led foreign exchange operations has the potential to confuse the public as to whether monetary policy is supposed to support short-term exchange rate objectives or longer-term anti-inflationary objectives. Which is why Goodfriend and Broaddus advocate legislation that enforces a complete separation of the Fed from the Treasury's forex operations.

Let's imagine a Yellen-led Fed successfully rebuffs Trump. Does the President have any other levers to influence the dollar?

Enter the Exchange Stabilization Fund, or ESF. When the Fed and Treasury partner to intervene in foreign exchange markets, it has always been the ESF that has been responsible for the Treasury's contribution to the intervention. This obscure account, managed by the Treasury Secretary, is entirely self-funding. This means that, unlike the Treasury's other expenditures, spending from the ESF is excluded from the congressional appropriation process. Only the President, not Congress, has the authority to review the Treasury’s decisions regarding ESF operations.

The ESF has an odd history. It was established in 1934 by the Gold Reserve Act with $2 billion worth of proceeds derived from the revaluation of the U.S. gold from $20.67 to $35 per ounce. It has been used not only as the Treasury's counterpart to the Fed in exchange interventions, but also as a tool to bailout foreign governments, including a Clinton-led rescue of Mexico in 1995. Courtesy of George Bush and Henry Paulson, the ESF was most recently tasked with guaranteeing U.S. money market mutual funds during the 2008 credit crisis.

As of December 2016, the ESF's assets clock in at a cool $90.4 billion. How much of this might Trump devote to riding down the dollar? Take a look at the ESF's balance sheet and you'll see that of that $90.4, the ESF has $22 billion in U.S. securities. So it could sell $22 billion right now in order to push down the dollar.

Scanning through the rest of the balance sheet, the ESF also owns $50.1 billion IMF special drawing rights, or SDRs. (I wrote about SDRs here). The Treasury has the power to monetize these SDRs by depositing them at the Fed in return for fresh dollars. For the curious, I've snipped the relevant section from the ESF's statements:


To date, $5.2 billion worth of SDRs have been monetized, so presumably that leaves another $45 billion left as firepower. Note that the Fed cannot legally refuse to accept SDRs that have been submitted for monetization.

The ESF also has euros and yen to the tune of ~$19 billion. While it can't sell these currencies in order to weaken the dollar, it can exploit a long tradition with the Fed called "warehousing." If the Treasury Secretary wants the ESF to sell dollars but it lacks the resources to do so, the Fed has typically offered to buy the ESF's forex assets up to a certain warehoused amount in return for dollars, the ESF agreeing to take on the exchange rate risk. Think of this as a repo, securitized loan, or swap. According to the Treasury, this Fed-determined limit is currently $5 billion, although during the 1995 bailout of Mexico the warehouse was temporarily increased to $20 billion. So of the ~$19 billion in yen and euros on the ESF's balance sheet, at least $5 billion could be automatically converted into dollars and sold via the Fed's warehousing facility.

Where does that leave us? $22 + $45 + $5 billion = $72 billion. That's a lot of dollars that the ESF can potentially sell. But would it be enough to have a real impact the exchange rate? Foreign exchange markets are massive. According to the BIS, daily spot trading in U.S dollars averaged $1.4 trillion in April 2016! The ESF seems like a drop in the bucket to me, no? Furthermore, the Fed would become the ESF's biggest enemy in this game. If the ESF were to be successful in pushing down the dollar, this would constitute monetary loosening and would have to be offset by the Fed lest it miss its inflation target. Nor is Congress likely to top up the ESF's firepower, as Russell Green points out here, given the odds of success are low.[1]

Suffice it to say that Trump can certainly score an initial symbolic victory by tasking the ESF to weaken the dollar, but he needs to have the unlimited firepower of the Fed if he wants to do true damage. And that firepower might not be forthcoming, at least as long as Janet Yellen—and not a Trump flunky—is holding the reins.


[1] One exception that Congress might agree to is the obscure $42.22 maneuver.
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Thursday, May 14, 2015

Greece and IMF SDRs—Gold Next?



The FT makes a hullabaloo out of Greece using special drawing rights (SDR) to pay the IMF earlier this week, referring to the step as "unusual." Zero Hedge predictably grabs the baton and runs as far as it can go with the story.

It's a good opportunity to revisit the SDR, a topic I last wrote about back in 2013.

The FT claims that the payment of SDRs to the IMF is "the equivalent of taking out a low-interest loan from the fund to pay off another." Here the FT has committed cardinal error #1 when it comes to understanding how SDRs work—SDRs are not lent out by the IMF.

I like to think of the SDR mechanism as comprised of 188 lines of credit issued to each of the IMF's 188 members. These lines of credit are denominated in SDR and apportioned according to each countries' relative economic size. Any line of credit needs a creditor. In the case of SDRs, who fills this role? Why, the 188 members of the IMF do. The SDR system is a mutual credit system, or what I referred to in my older post as the world's largest Local Exchange Trading System, or LETS. Where does the IMF stand in all this? It is simply an administrator of the system. So by paying the IMF in SDRs, the Greek government isn't taking out a low-interest loan from the IMF—rather, it's drawing down on the credit provided to it by 187 other countries. As for the IMF, it isn't getting another Greek-issued debt instrument. Rather, it is getting a mutual liability of 188 nations.

The second sin in the FT's article is the assumption that SDRs are "rarely tapped" and that therefore, Greece is doing something unusual in "raiding" its SDR account. As a quick glance to the data shows, that's simply not the case. The chart below (apologies for its extreme height, but it's the only way I can visualize the data) shows that over time,  countries have tended to spend down their SDR lines of credit. Any nation to the left of the 100% line (and illustrated in light blue) has drawn down on their credit line while those to the right (illustrated in darker blue) have accumulated SDR surpluses. Most countries lie to the left of the line. Greece, which after this week's transaction has just 5% of its total line of credit undrawn*, joins Macedonia, Iceland, Hungary, Serbia, Ukraine, and Romania near the low end of the range, many of whom drew down their balances to deal with the after-effects of the credit crisis.

Data Source


Nor is the FT article right in implying that it is unusual for countries to pay the IMF in SDRs. Consider that since the SDR's inception in 1969, 204 billion SDRs have been issued to 188 member nations. Logic tells us that each of these 204 billion SDRs must be owned by some combination of member nations, right? Not quite. The 188 nations collectively own only 189 billion SDRs. Who holds the missing 15 billion SDRs? Fifteen institutions, or proscribed holders, have been granted the ability to buy and sell SDRs in the secondary market, including the Arab Monetary Fund, the Bank for International Settlements, and the European Central Bank. Together they own about 1.2 billion SDRs. But the real sop here is the IMF itself, which owns around 13.5 billion SDRs. Because IMF members can use SDRs in transactions involving the IMF, namely the payment of interest on and repayment of loans (see here), the IMF has become the second largest owner of SDRs (after the U.S.).

So in general, the SDR mechanism has been characterized by steady drawdowns of SDR lines of credit by member nations, with surpluses accumulating to the IMF. Far from being unusual, Greece's decision to pay the IMF in SDRs is pretty much par for the course.

One thing I find interesting is that the SDRs that Greece used to pay the IMF are the property of the Bank of Greece, Greece's central bank, and not the Greek government (see here). This means that BoG Governor Yannis Stournaras had to willingly open his pockets to the Greek government to facilitate the IMF payment. In doing so, the central bank has accepted a Greek government-issued liability to pay back SDRs rather than the actual SDRs. As a claim on 187 nations, the latter is surely preferable to the former, which is a claim on a failing nation.

So what about the BoG's other larger unencumbered asset, its gold? According to its most recent balance sheet, the Bank of Greece now owns €5.4 billion of the yellow metal, or 3.62 million ounces. For more on Greece's gold, Ronan Manly has the details. Having just given up his SDRs, would Stournaras be willing to render this gold up to the Greek state in return for a gold-denominated IOU with finance minister Yanis Varoufakis's signature on it? If so, the Greek government could sell this gold on the market for euros to pay the IMF. Settling scheduled June and July payments would be a breeze. This would no doubt be a stain on the BoG's independence, but with the Eurogroup turning the screws, all chips may be in play.



*I'm assuming that Greece paid 517 million SDRs to the IMF, worth 650 million euros at current SDR-to-euro exchange rates.
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Saturday, May 11, 2013

IMF SDRs: the world's largest LETS

IMF board room

I like to think of the International Monetary Fund's special drawing rights (SDR) program as the world's largest Local Exchange Trading System, or LETS. A truly unique part of the monetary landscape, what follows is a short visual essay on SDRs.

What is an SDR?

An SDR has two aspects. First, an SDR is a unit of account, or, put differently, a measure of value. As a unit-of-account, the SDR is defined by the IMF in terms of a reference good, or a medium of account. When the SDR was first introduced in 1969, an SDR was defined as 0.888671 an ounce of gold, so the yellow metal was the SDR's first medium of account. The IMF later redefined the SDR as a certain quantity of central bank currencies. As of 2012, an SDR is comprised of a basket of 0.423 euros, 12.1 yen, 0.111 pounds, and 0.66 US dollars. Thus the modern day SDR is defined in terms of multiple media of account.

The Suez Canal Authorities currently uses the SDR to calculate the Suez Canal Tariff, while the the Universal Postal Union, which coordinates international postal duties, uses the SDR as a unit of account. Apart from these and a few other rare examples, the SDR is not a popular unit of account.

In addition to existing as a unit of account, SDRs also function as media of exchange. This is the aspect of SDRs I'll focus on from here on in.

SDRs as LETS

In many ways, the SDR system represents a souped-up Local Exchange Trading System, or LETS. In a LETS, each member of a local community gets an initial line of credit. These credits, which are accepted by all members of the LETS, are liabilities, or claims, of all LETS members on each other. A LETS member can spend down their line of credit by purchasing stuff from other members, and replenish their line of credit when others spend at their own shop. No one can spend more than their line of credit.*

All LETS need an administrator. The administrator takes on no risk, nor are they liable for credits issued. They simply maintains the books of the LETS and ensure that the system operates efficiently.

Much like a LETS administrator maintains a LETS, the IMF "SDR Department" maintains the SDR system. SDRs are not issued by the IMF, nor are they claims on the IMF. Rather, the community of nations jointly issues SDRs. In the SDR system, each country's respective line of credit is referred to as its "allocation" of SDRs. In general, the larger a nation's GDP, the greater its allocation. The US's current allocation is around SDR 35 billion, whereas Canada's is SDR 6 billion. Cyprus's allocation amounts to a meager SDR 132 million. (One SDR is worth about US$1.50, so Canada's stash of SDRs comes out to around $9 billion)

SDR holdings vary over time as SDRs are spent from nation to nation and as new credits are created. The chart below shows total SDRs in existence. It gives a sense of how SDRs are distributed between some of the program's largest members and blocks.


Individual members can't simply create new SDRs willy nilly. All members must jointly agree to create them. In 1971, 1972, 1979, 1980, and 1981 the total amount of SDRs was increased, but after that a long freeze set in. In 2009, in the midst of the credit crisis, members agreed to an increase in SDR credits from $21 billion to $204 billion. You'll notice in the chart that the BRICs received a far larger shot of SDRs than they did during previous allocation top-ups because their relative position in world GDP has increased so much.

It's particularly interesting to break down the distribution of SDRs. Over time, members will either spend away their SDR credits so that they are holding less SDRs than originally allocated, or they will acquire SDRs so that they are holding more than they were originally allocated. Surplus nations receive interest payments from deficit nations.** We can see the distribution of surplus and deficit countries in the histogram below. In general, far more countries are in an SDR deficit position than a surplus position. Put differently, most counties hold less SDRs than they were initially allocated.


...which doesn't make much sense. If countries spend away SDRs, someone must be left holding the bag. SDRs cannot be uncreated. This is where the IMF once again re-enters our story. While only states can enjoy SDR allocations, certain supranational organizations like the IMF are allowed to purchase SDRs from states after SDRs have been created.*** As my first chart shows, the IMF is a large holder of SDRs and possesses a portfolio that shows much more volatility in scope than the other nations and blocks.

Let's explore this more. The chart below ranks all countries by the excess of holdings over allocations. Deficit countries lie below 0, surplus ones are above. I've added the IMF too which, as the chart shows, is by far the system's largest accumulator of SDRs. The IMF currently holds around SDR 12.7b. The only reason that most countries on the chart are able to be in deficit positions is because the IMF serves as an SDR sop.


Try playing with the slider above by pulling the top tab from 12,691 down to 0 or so. This filters out the IMF and the surplus nations, thereby providing more resolution on the system's greatest deficit countries, which includes the Ukraine, India, Romania, and Hungary. The Ukraine, for instance, has sold of SDR 1.3 billion of its initial allocation (more on this later).

It's also useful to rank countries by their percent surplus/deficit rather than their absolute surplus/deficit. In the chart below, those countries distributed close to the 100% level have about the same number of holdings that they were initially allocated. Anyone over the 100% line holds more SDRs than they were allocated, and those below 100% have been sellers.



Use the slider above to zoom in on the biggest surplus countries. Oddly, you'll see that Libya leads the pack, holding 150% of its initial allocation. One reason for this may be the fact that the Libyan dinar is pegged to the SDR, a link that has been in place since 1986. A buffer of SDRs would be necessary for the Libyan monetary authority to protect the peg. According to the Sadeq Institute, the choice of the SDR was made by the Gadaffi regime in "symbolic retaliation" to the US. Prior to 1986, Libyan dinar's had been pegged to USD. Botswana also has an outsized SDR portfolio. The Botswanan Pula has been pegged to a mix of the South African rand and the SDR since 1980, a policy that would presumably require a large stock of SDRs.

Zooming in on the deficit side of the chart, you'll see that the Ukraine is the third largest deficit nation, having sold all but 0.45% of its initial allocation. Ukraine was hit hard by the 2008 credit cirsis. It also imports terrific amounts of natural gas, much of which gets exported on to Western Europe. In order to pay its natural gas bill late in 2009, it used almost its entire SDR allocation.

Is a nation's per capita GDP related to its status as SDR debtor or SDR creditor? The chart below charts per capita GDP along the x-axis and SDR position along the y-axis.


Most rich nations, those in the two right quadrants with per capita GDP in excess of $10,000, tend to cling closely to 1.0. They are neither in large surplus nor deficit positions relative to the system. Iceland and Hungary, which hover near the bottom of the bottom-right quadrant, are outliers. Both have per capita GDP's above $10,000 but have largely drawn down their SDR balances. Hungary, which only received its first allocation of SDRs in 2009, was hit hard by the financial crisis and  forced to liquidate many of its new SDRs in order to meet bills.

What all these charts illustrate is that except for the IMF (and a few countries that fix to the SDR), only a minority of countries have been net purchasers of SDRs. Most have been sellers. Put differently, members of the SDR LETS have been quite content to be short SDRs, not long. Why? Many poorer countries are no doubt forced by circumstances to sell off a large part of their allocation. But even then, a large proportion of wealthy countries including almost every European nation, the UK, Australia, India, Brazil, and Canada are in deficit.

I'm speculating here, but the general aversion among states to holding SDRs may be due to a weak point that the SDR system shares with any other LETS system. Consider this: what happens to a LETS when a member in deficit splits town only to never be seen again? If the departing member fails to rebalance their account prior to leaving, then the amount by which they are in deficit will never be recouped by remaining members. All members must collectively absorb the loss. The same goes for SDRs. If Iran wishes to leave the system, what guarantees that prior to departure they'll honour their obligation to the system by purchasing enough SDRs to return them to an even level?

Taking this even further, imagine if a large block of deficit nations left the SDR system. What guarantees that SDRs will continue to be valued at their stipulated value of 0.423 euros, 12.1 yen, 0.111 pounds, and 0.66 US dollars? Remaining nations may start to bid SDR prices down until SDRs trade at a wide deficit to their ideal value in terms of media of account. At some point, the IMF might be required to announce a lower value for the SDR in order to catch up to its declining market value.

Alternatively the IMF could prop the system up by purchasing all SDRs at their ideal value of 0.423 euros, 12.1 yen, 0.111 pounds, and 0.66 US dollars. If it did so, the IMF would be left holding a large chunk of the system's SDRs.

But hold on a sec... isn't that already the case? Most countries have been net sellers, leaving the IMF (and other supranationals) currently holding some 6.2% of the total SDR float. This might be a sign that member nations have from time to time valued the SDR at somewhat less than 0.423 euros, 12.1 yen, 0.111 pounds, and 0.66 US dollars and, given the opportunity to sell at an overvalued rate to the IMF, they have seized that opportunity. The asymmetric distribution of SDRs does not give one much confidence in SDRs as assets.


*Many LETS do not limit member lines of credit. They leave it up to members to self-monitor the system.
**The SDR system defers markedly from a LETS in this respect. Most LETS frown on interest payments.
*** Other parastatals currenlty holding SDRs inclue the Arab Monetary Fund, Bank for International Settlements, Bank of Central African States, Central Bank of West Africa, European Central Bank, and the Islamic Development Bank. Total holdings of these instituitions comes out to about 1/12th that of the IMF's SDR holdings.
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Saturday, February 4, 2012

IMF and SDRs

A few thoughts on the IMF and SDRs over at the Money View.

The IMF and the SDR program are difficult to de-consolidate:

As far as I know, the IMF doesn't run the SDR program on its own balance sheet, it just administers the SDR program. Using your example, the EU and the US issue promises to currency which are held in some mutual account managed by the IMF, and that account in turn issues SDRs back to the EU and US. So in effect, the IMF doesn't swap its own promises with the EU and the US. Rather, the US and EU are swapping promises with each other with the IMF as facilitator.

That being said,

The last time I checked, the IMF was the largest owner of SDRs, all held on its own account. 
Here is the current distribution of SDRs across nations and institutions.
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