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March 7, 1 980

Substitution Accou nt
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 "SD R
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
I MF 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 functioning of the international monetary system.
The idea of a reserve-substitution account
goes back to the 1 943 "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 Iities. 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.

Reserveincrease
The increase in foreign-exchange reserves
has been rapid indeed, reflecting the
uncertainties created by OPEC price
increases, soaring inflation, and other factors.
From $1 8billion in 1 960, the total amount

rose to $45 billion in 1 970 and roughly $300
billion in September 1979. The rate of
increase accelerated from 9 percent a year
during the 1 960's to 24 percent a year in the
1 970'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 1 973 to 1 979, 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
$1 50 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 foreignexchange holdings has consisted of
dollar assetsthroughout the 1 970's. At the
end of 1 978, for example, $21 9 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 Eurocurrency deposits.

u.s:

Reserve
diversification
Although dollar assetsamounted to roughly
three-fourths of identifiable foreign-exchange
assetsthroughout 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 resuIt 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 WorldFinancial
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 1 979considerably less than the 1 2.6-percent
return for the japanese yen, 1 2.5 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 percent a year, compared to
2.3
annual gains ranging between 0.1 percent
(the British pound) to 2.4 percent (the
japanese yen).

The latter were created on January 1, 1 970,
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 1 6 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
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 weightedaverage 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.

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 foreignexchange 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.

Since the proposed substitution of the
SDR-denominated asset for dollar reserves
would be entirely voluntary, the new asset
must offer sufficiently attractive termsincluding interest yields, liquidity,
transferability, and safety from exchange riskto 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.

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 IM F's
SDR Account. Participating member
countries could freely convert their foreignexchange holdings into the new asset issued
by the Account without going through the
foreign-exchange market.

Issuesto be resolved
Liquidity and transferability. The present

The new assetswould be denominated in
SDRs, but would not themselves be SDRs.

official foreign-exchange reserves are held in
assetsof varying maturities, and possessvary2

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.

ing degrees of liquidity and transferability.
Given the wide range of choice, official assetholders 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 reserveassets.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 possessboth high liquidity and
highly stable exchange value.

Sizeof account. To do any good, the size of
the Account must be substantial relative to
the size of existing official
holdings of more than $300 billion. Other
reserve-assetpositions in 1 979 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 $1 0 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 IM F to
the possibility of incurring substantial costs in
providing for exchange risk-a proposition of
dubious political acceptability.

Exchange
risk. If the store-of-value attribute
of the new assetwere 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 assetswere converted into
SOR-denominated assetsin 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 asking the IMF to share the cost wou Id be
tantamount to asking alll M F 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.

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

Interestpayment.How to balance exchangevalue safety against interest-rate attractiveness is a technical question that would
3

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BANKINGDATA-TWElffH FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)

Selected ssets Uabilities
A
and
large Con1mercial
Banks
Loans(gross,adjusted)and investments*
Loans(gross,adjusted)- total#:
Commercial and industrial
Realestate
Loansto individuals
Securitiesloans
U.s. Treasurysecurities*
Other securities*
Demand deposits- total#:
Demand deposits- adjusted
Savingsdeposits- total
Time deposits- total#
Individuals,part. & corp.
(LargenegotiableCD's)

Weekly
Averages
of Daily f'egures
Member ankReserve osition
B
P
Excess
Reserves )/Deficiency (-)
(+
Borrowings
Net freereserves )/Net bonowed( -)
(+
Federal
Funds SevenI.argeBanks
Net interbanktransactions
[Purchases )/Sales(-)]
(+
Net, U.s. Securitiesdealer transactions
[Loans(+)/Borrowings (-)]

Amount
Outstanding
2/20/80

Change
from
2/13/80

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

+ 390
+ 420
+ 204
98
+
13
+ 138
42
12
+
+1,349
- 477
1
346
307
- 479

Weekended
2/20/80

Changefrom
year ago
Dollar
. Percent
;

+ 17,047
+ 14.0
+ 16,813
+ 16.9
+ 4,596
+ 15.8
+ 24.6
+ 8,808
+ 18.3
+ 3,774
I
366
- 18.9
733
9.6
967
+
+ 6.7
+ 3,829
+ 9.3
+ 2,354
+ 8.3
1,669
I
5.6
I
+ 7,950
+ 15.6
+ 8,891
+ 21.5
I
+ 10.5
+ .1,987
Weekended
Comparable
year-agoperiOd
2/13/80

,

I.

78
291
212

23
181
205

12
75
87

+2,911

+2,212

+2,129

23

59

-

+

+

572

• Excludestrading account securities.
:/I:Includes items not shown separately.
Editorial omments maybe addressed the editor(WilliamBurke) to the author•••• Freecopies this
c
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of

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Reserve
publications beobtainedby callingor writing the PublicInformation
can
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Federal eserve
R
Bank SanFrancisco, Box7702,San
of
P.O.
Francisco
94120.Phone
(415)544-2184.