SDR Changes: Evolution or Revolution?

Do potential changes in the composition of the International Monetary Fund’s Special Drawing Rights (SDR) basket represent an evolution or revolution in the international monetary system?

Bullion.Directory precious metals analysis 4 April, 2015
By Terry Kinder
Investor, Technical Analyst

For more than 40 years there have been predictions of the demise of the dollar. One of the classic reads is Harry Browne’s “How You Can Profit from the Coming Devaluation.” Browne’s book was brilliant not only because he foresaw the coming dollar devaluation that occurred under President Nixon, but also because the book pointed to the essential role that gold plays in providing necessary protection during times of monetary crisis.

While Browne got many things right in his book, he also missed the mark in several instances. For example, while not calling explicitly for a depression, he certainly featured it as a possible scenario. Hand in hand with the idea of a depression was the idea of societal breakdown, civil disorder and the necessity of having a retreat where you could go to escape from the chaos of a collapsing economy. All of these concepts are echoed again today and have been discussed at length since before the Global Financial Crisis (GFC). None of this is to say that the things Browne discussed won’t come to pass eventually, but the events have unfolded much more slowly than he, and many others, anticipated.

Emerging China, the Yuan and the SDR

As China has risen to become a significant economic power, many have assumed some dramatic event could occur that would rapidly unseat the dollar as the world reserve currency. It isn’t an impossibility. However, dollar collapse scenarios imply a worldwide economic collapse. Again, it’s not impossible, but logic dictates that a worldwide economic collapse – which is what a dollar collapse would represent – is not a good outcome, even for U.S. rivals such as China or Russia. Rather, it makes more sense for some kind of transition away from the dollar and toward a more balanced international monetary system.

Enter the SDR

Despite all of the speculation that China and Russia have been purchasing gold in order to back their currencies with the yellow metal, and therefore unseat the dollar, I don’t think that is their immediate goal. Instead, Russia and China realize that militarily they are currently no match for the United States. A still militarily powerful U.S., in a state of economic collapse, is dangerous for China, Russia and the rest of the world. Instead, China and Russia have decided to hedge their bets by moving out of dollar denominated assets and, in part, into gold. This has allowed them to diversify out of the dollar and obtain gold – something they believe will hold its value over time. Additionally they have taken steps to break free from the dollar dominated international monetary system. This has taken on more urgency as the U.S. has taken punitive economic measures against Russia over Ukraine, including the threat of locking Russia out of the SWIFT system.

Action-Reaction

The willingness of the U.S. to use sanctions to inflict harm on Russia no doubt accelerated efforts on the part of China and Russia to not only build a parallel set of international monetary institutions outside the control of the U.S., e.g. Asia Infrastructure Investment Bank (AIIB), New Development Bank, China International Payment System (CIPS), etc., but also to increase their standing within the current international monetary system. All of which leads us to where we are today with the composition of the SDR.

The SDR basket composition will once again be adjusted with the first formal meeting to review the weights taking place in May, 2015. The composition will be confirmed in October, 2015, with the changes taking effect on January 1, 2016.

Philosphy of Metrics (POM) has been one of the leading sources of information about potential changes in the composition of the SDR, and recently has proposed some interesting potential changes to the basket. POM believes that the SDR will be expanded from the current four currencies – U.S. Dollar, European Union Euro, Japanese Yen, and Great British Pound to include three more currencies. Those currencies would be the Swiss Franc, Canadian Dollar and Chinese Yuan.

Three Potential SDR Baskets

Furthermore, POM outlined the following three potential SDR Baskets:

• Potential SDR Basket #1: USD 33%, Yuan 33%, Euro 20%, Yen 7%, Pound 7%
• Potential SDR Basket #2: USD 26%, Yuan 26%, Euro 14%, Yen 10%, Pound 10%, Swiss Franc 7%, Canadian Dollar 7%
• Potential SDR Basket #3: USD 20%, Yuan 20%, Gold 20%, Euro 12%, Yen 8%, Pound 8%, Swiss Franc 6%, Canadian Dollar 6%

Yes, that last basket includes gold. I imagine that China and Russia would be quite pleased with that outcome given their efforts over the past few years to accumulate more of the yellow metal.

SDR Changes: Evolution or Revolution?

It isn’t yet clear whether changes to the SDR would represent an evolution or revolution. Certainly the inclusion of gold, should it come to pass, would represent a sort of counter-revolution to an international monetary system that has largely denied gold had any legitimate role to play for the better part of the last forty years or better.

At the same time, inclusion of China in the SDR would signal an evolutionary move away from the U.S. Dollar as the sole pillar of the international monetary system. While the U.S. clearly remains the dominant military power in the world, the inclusion of the Chinese Yuan within the SDR Basket would signal international recognition of China’s increasing importance as an economic power.

Conclusion

It appears that the international monetary system will slowly move away from dependence on the U.S. Dollar as its sole pillar and, instead, move towards a more multilateral system to include the Chinese Yuan and other currencies within the SDR Basket. Whether or not the SDR becomes a replacement for the dollar is not yet clear. It could, perhaps, be an intermediate step toward a world currency, but that remains to be seen.

The inclusion of gold within the SDR Basket is one possibility outlined by POM, amongst others. The inclusion of gold in the SDR Basket may further imply a revaluation of the gold price upward as a means of restoring public confidence in the international monetary system.

Certainly, if gold is included in the SDR – which is by no means certain – it could bolster the status of both Russia and China, vis a vis, the United States, and the dollar, within an evolving international monetary order, and prove that their efforts to acquire gold were ultimately warranted.

Keep a watchful eye out for further developments with the SDR. While it certainly isn’t guaranteed, changes in the SDR Basket will likely have significant long-term impacts on the relative value of fiat currencies and, potentially, on the price of gold measured in those same currencies.

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