International Monetary Fund ; Special drawing rights ; International finance

Hang-Sheng Cheng

English

Research Papers in Economics

March 7,  1980 
Substitution Account 
A major innovation in the international 
monetary system has appeared on the 
horizon. The Executive Board of  the 
International Monetary Fund (lMF) is now 
working on a proposal to establish an "SDR 
Substitution Account," at which member 
countries could convert their foreign-reserve 
holdings now denominated in national 
currencies (mostly U.S. dollars) into claims 
denominated in IMF Special Drawing Rights 
(SDRs). The IMF's Interim Committee on the 
International Monetary System agreed upon 
the plan in principle at the IMF Annual 
Meeting in Belgrade last October. 
Furthermore, the Committee instructed the 
IMF Executive Board to subm it detai led plans 
for implementation at the Committee's 
meeting in Hamburg next month. Prospects 
are still uncertain, but the proposal has 
attracted considerable attention among those 
interested in the stability and smooth function-
ing of  the international monetary system. 
The idea of a reserve-substitution account 
goes back to the 1943 "Keynes Plan" of an 
International Clearing Union, under which 
an international reserve asset (the "bancor") 
would be created to provide for international 
payments clearance as well as overdraft 
faci I  ities. For almost forty yearsrthe idea of  an 
international reserve asset has recurred in 
various forms and (as discussed below) has 
been realized in the form of SDRs. However, 
the more immediate impetus for the 
substitution-account proposal stems from the 
world's growing concern over the rapid 
increase in foreign-exchange reserves, and 
over the potentialdisturbance to the 
exchange market caused by massive shifts of 
reserves from one currency to another. 
Reserve increase 
The increase in foreign-exchange reserves 
has been rapid indeed, reflecting the 
uncertainties created by OPEC price 
increases, soaring inflation, and other factors. 
From $18billion in 1960, the total amount 
rose to $45 billion in 1970 and roughly $300 
billion in September 1979. The rate of 
increase accelerated from 9 percent a year 
during the 1960's to 24 percent a year in the 
1970's. Surprisingly, the general floating of 
exchange rates did not result in any 
slowdown of  world-reserve accumulation. 
On the contrary, under managed float, world 
foreign-exchange reserves rose at 17 percent 
a yearfrom 1973 to 1979, considerably faster 
than the 9-percent annual average rate of  the 
1960's. The expansion since 1973:was 
widespread: from $66 billion to more than 
$150 billion for industrial countries, from 
$12 billion to $57 billion for oil-exporting 
countries, and from $44 billion to $94 billion 
for non-oil developing nations. 
These foreign-exchange reserves all 
represent claims against individual countries. 
It is impossible to identify fully all the debtor 
countries involved. However, according to 
IMF data, the bulk of  official foreign-
exchange holdings has consisted of u.s: 
dollar assets throughout the 1970's. At the 
end of 1978, for example, $219 billion (or 76 
percent) ofthe  total was denominated in U.S. 
dollars, including Eurodollars. At the same 
time, the total identifiable reserve assets 
denominated in major currencies other than 
the dollar amounted to about $35 billion, of 
which more than half consisted of Euro-
currency deposits. 
Reserve diversification 
Although dollar assets amounted to roughly 
three-fourths of  identifiable foreign-exchange 
assets throughout the 1970's, there is little 
assurance thatthe ratio will remain stable in 
future years. Central banks generally are not 
profit-seeking institutions, but they cannot be 
completely oblivious of any sustained 
erosion ofthe real purchasing power oftheir 
reserve assets. And no matter what central 
banks do, private international-asset holders 
would not feel obligated to retain an asset in 
their portfolios if its yield has· become much 
less favorable relative to other assets. il-l  this nevvsletter do not 
In this regard, the attractiveness of  dollar 
holdings has deteriorated perceptibly over 
the last few years, as a resu It of accelerated 
inflation in the United States and a 
precipitous decl ine of  the dollar agai nst other 
major currencies. According to Morgan 
Guaranty's World Financial Markets 
(September 1979), when exchange-rate gain 
was added to interest yield, reserves held in 
U.s. dollars earned 7.4 percent annually 
between january 1975 and August 1979-
considerably less than the 12.6-percent 
return for the japanese yen, 12.5 percent for 
gold, 11.8 percent for the Swiss franc, and 
10.0 to 10.6 percent for the German mark, 
British pound and French franc. When 
adjustment was made for world inflation (in 
terms of world manufactured-goods prices) 
reserves held in U.S. dollars earned a 
negative 2.3 percent a year, compared to 
annual gains ranging between 0.1  percent 
(the British pound) to 2.4 percent (the 
japanese yen). 
Past performance is not necessarily a reliable 
guide to future prognostication, but there 
may be some justification for the concerns 
expressed about the danger to the foreign-
exchange market of any massive reserve 
diversification out of the dollar, from either 
private or official portfolios. As stated above, 
these concerns have helped stimulate the 
movement to create an international asset 
that could be substituted for reserve holdings 
denominated in national currencies, in a 
manner that would completely short-circuit 
the foreign-exchange market. 
SDR-den"ominated asset 
The balances in the proposed Substitution 
Account are intended to serve that purpose. 
They would be denominated in SDRs, but 
kept in a separate account from the IMF's 
SDR Account. Participating member 
countries could freely convert their foreign-
exchange holdings into the new asset issued 
by the Account without going through the 
foreign-exchange market. 
The new assets would be denominated in 
SDRs, but would not themselves be SDRs. 
2 
The latter were created on January 1, 1970, 
with an initial distribution to participants of 
an equivalent of $3.5 billion, and additional 
$3-billion equivalents were created and 
distributed on each ofthe following two New 
Year's Days. Each SDR is valued at the 
weighted-average value of 16 major 
currencies: the U.S. dollar (33 percent), the 
German mark (12.5 percent), the British 
pound (7.5 percent), etc. As a weighted 
average, the value of  the SDR tends to be 
more stable than the constituent currencies. 
An SDR credit-balance at the IMF can be 
used by a defi~it country to purchase other 
participating countries' currencies, either by 
agreement with the latter countries or at the 
"designation" of the IMF as the Account 
Manager. Net users of  the Account are under 
obi  igation to "reconstitute" the credit 
balance within a designated number of  years. 
Finally, credit balances in the SDR Account 
pay an interest rate equ iva  lent to 72 percent 
of  a weighted average of  the interest rates in 
five major national markets (the U.S., U.K., 
France, Germany, and japan), while debit 
balances are charged an interest rate 
equ ivalent to 80 percent of  the weighted-
average rate. Because of  the restrictions on its 
transferability, its lower interest yield, and 
reconstitution obligation, the SDR is 
generally considered to be a less desirable 
asset than, say, a dollar asset. 
Since the proposed substitution of  the 
SDR-denominated asset for dollar reserves 
would be entirely voluntary, the new asset 
must offer sufficiently attractive terms-
including interest yields, liquidity, 
transferability, and safety from exchange risk-
to make it competitive with existing assets 
denominated in national currencies. In other 
words, the new asset, though denominated in 
SDRs, must offer significantly more attractive 
terms than existing SDRs to achieve its 
intended purposes. 
Issues to be resolved 
Liquidity and transferability. The present 
official foreign-exchange reserves are held in 
assets of  varying maturities, and possess vary-ing degrees of liquidity and transferability. 
Given the wide range of  choice, official asset-
holders can tailor their asset portfolios 
according to their individual preferences. 
Obviously, it would not be feasible for the 
new asset to compete with the entire 
spectrum ofexisting reserve assets. However, 
policymakers might be well-advised to 
decide which specific types of  existing assets 
the new asset would substitute for. For 
instance, the new asset conceivably could 
provide a better long-term store of value than 
existing reserve assets, in which case the 
integrity of'capital value would be stressed 
more than its short-term liquidity. It might be 
both unrealistic and unnecessary to require 
the asset to possess both high liquidity and 
highly stable exchange value. 
Exchange risk. If the store-of-value attribute 
of the new asset were to be its principal 
attraction, the Account must stand ready to 
assume at least a part of  the exchange risk 
now borne by official reserve holders. If, for 
instance, dollar assets were converted into 
SOR-denominated assets in the Account, and 
subsequently the dollar depreciated against 
the SOR, the Account would suffer a paper 
loss even in the absence of any account 
withdrawals, and would suffer an actual loss 
in the event of liquidation. Who would then 
bear the loss? If all the participants were to 
bear the loss in proportion to their balances in 
the Account, their losses would be no less 
than they would have been if  they had not 
converted their holdings into the new asset. 
Only if a non-participant-say, the U.s. or 
the IMF -were  to share at least a portion of 
the loss, wou  Id the new asset confer greater 
exchange safety than existing dollar assets. 
But aski ng the IMF to share the cost wou  Id be 
tantamount to asking alllMF member 
nations-haves and have-nots alike-to 
share the cost of protecting the asset value of 
the haves. Also, asking the U.S. to share the 
cost would raise a question of political 
acceptability to the U.S. Congress. 
Interest payment. How  to balance exchange-
value safety against interest-rate attractive-
ness is a technical question that would 
3 
require careful analysis. Since an exchange 
guarantee wou  Id be equ ivalent to provid  i ng a 
forward cover, the interest-rate differentials 
between the new asset and existing assets 
might offer interesting opportunities of 
covered arbitage. Moreover, as past 
experience with SORs has shown, setting an 
appropriate interest rate is no mean task. 
Unattractive yields would keep asset-holders 
away, and excessively generous rates might 
threaten the Account's financial viability. 
Size of account. To do any good, the size of 
the Account must be substantial relative to 
the size of  existing official foreign""~xchange 
holdings of more than $300 billion. Other 
reserve-asset positions in 1979 were 
relatively small: the IMF General Resource 
Account totaled only $9 billion, the SOR 
Account $18 billion, the Agreement to 
Borrow $9 billion, the Oil Facility Account 
$4 billion, and the Supplementary Financing 
Facility $10 billion. Would the proposed 
Substitution Account also be of limited size, 
or wou  Id it be open-en.ded on demand of  the 
participants? Herein lies a dilemma. A small 
size would be no more than tokenism,  . 
yielding little real benefit to the international 
monetary system; an open-ended account 
would mean exposing the u.s. or the IMF to 
the possibility of  incurring substantial costs in 
providing for exchange risk-a proposition of 
dubious political acceptability. 
Altogether, the Substitution Account is a 
bold, ambitious plan to tackle a potentially 
serious international financial problem. The 
IMF staff is now working intensively to have 
the plan ready for submission to the IMF 
Interim Committee on April 25. Several issues 
remain to be resolved, and how they are 
resolved will determine the plan's feasibility 
and usefulness. Financial experts everywhere 
will be watching with interest what kind of a 
proposal, if  any, will emerge from the Interim 
Committee's meeting. 
Hang-Sheng Cheng SS,",1:> lSI:II:I 
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BANKING DATA-TWElffH FEDERAL RESERVE DISTRICT 
(Dollar amounts in millions) 
Selected Assets and Uabilities 
large Con1mercial Banks 
Loans (gross, adjusted) and investments* 
Loans (gross, adjusted) - total#: 
Commercial and industrial 
Real estate 
Loans to individuals 
Securities loans 
U.s. Treasury securities* 
Other securities* 
Demand deposits - total#: 
Demand deposits - adjusted 
Savings deposits - total 
Time deposits - total # 
Individuals, part. & corp. 
(Large negotiable CD's) 
Amount 
Outstanding 
2/20/80 
138,574 
116,149 
33,634 
44,557 
24,419 
1,569 
6,922 
15,503 
45,088 
30,806 
28,131 
58,996 
50,340 
20,860 
Change 
from 
2/13/80 
+  390 
+  420 
+  204 
+  98 
13 
+  138 
- 42 
+  12 
+1,349 
- 477 
1 
346 
307 
- 479 
; 
, 
I 
I. 
I 
I 
I 
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Change from 
year ago 
Dollar  . Percent 
+  17,047  +  14.0 
+  16,813  +  16.9 
+  4,596  +  15.8 
+  8,808  +  24.6 
+  3,774  +  18.3 
- 366  - 18.9 
- 733  - 9.6 
+  967  +  6.7 
+  3,829  +  9.3 
+  2,354  +  8.3 
1,669  - 5.6 
+  7,950  +  15.6 
+  8,891  +  21.5 
+  .1,987  +  10.5 
Weekly Averages  Weekended  Weekended  Comparable 
of  Daily f'egures 
Member Bank Reserve Position 
Excess Reserves (+  )/Deficiency (-) 
Borrowings 
Net free reserves (+  )/Net bonowed( -) 
Federal Funds - Seven I.arge Banks 
Net interbank transactions 
[Purchases (+  )/Sales (-)] 
Net, U.s. Securities dealer transactions 
[Loans (+)/Borrowings (-)] 
• Excludes trading account securities. 
:/I:  Includes items not shown separately. 
2/20/80 
78 
291 
- 212 
+2,911 
+  23 
2/13/80  year-ago periOd 
23  12 
181  75 
205  87 
+2,212  +2,129 
59  +  572 
Editorial comments may be addressed to the editor (William Burke) or to the author •••• Free copies of this 
and other Federal Reserve publications can be obtained by calling or  writing the Public Information Section, 
Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184. 

Substitution account

http://www.frbsf.org/publications/economics/letter/1980/el80-10.pdf

Substitution account

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Research Papers in Economics