Foreign Relations of the United States, 1977–1980, Volume III, Foreign Economic Policy

198. Briefing Memorandum From the Acting Assistant Secretary of State for Economic and Business Affairs (Hormats) to the Under Secretary of State for Economic Affairs (Cooper)¹

Washington, February 8, 1979

SUBJECT

• Dollar Substitution and SDRs; IMG Meeting on February 9

The February 9 IMG meeting will discuss an IMF staff paper which put forward three ideas on how a substitution account could be structured.² The Fund’s Executive Board is scheduled to discuss the paper on February 12, and the USED will look to the IMG discussion to frame his reaction. A copy of the Fund staff paper and a memo from USED Sam Cross are attached.³ This memo reviews some of the general issues involved in a dollar substitution account and comments on the three specific ideas presented in the IMF staff paper.

Background

Arguments for a substitution account are generally based on two premises: (1) the substitution of dollars for SDRs would give greater stability to the monetary system by permitting diversification of reserves and thus reducing the vulnerability of major currencies to sudden demand shifts; and (2) a substitution account would advance the role of the SDR as the primary international reserve, a goal endorsed in the amended IMF Articles of Agreement.⁴

The first premise relates to claims that dollar weakness and systemic instability are directly connected to “excessive” dollars held overseas. One way to soak up “excess” dollars, the IMF staff concludes, would be a new account which would allow the substitution of the SDR for dollar holdings.

The second is the envisioned role of the SDR as the primary international reserve. Marginal allocations of SDRs to existing international liquidity will not move the SDR to the center of the international monetary system. In addition, increases in international liquidity should not be dependent on the deficits of reserve currency countries. It is argued that the creation of international liquidity should be delegated to an international body, the IMF, which would have power to regulate the creation of reserve assets. One goal of the substitution account would be the transformation of the current dollar-centered system.

The issues underlying USG discussion of a substitution account are, of course, our fundamental objective in the international monetary system and how it should be strengthened over the long run. Positions on the concept of the dollar substitution will reflect views on those basic questions.

Problems of a Substitution Account

The idea of a substitution account merits considerably more examination. However, current proposals for a substitution account, including the ideas discussed in the IMF paper, have failed to deal with three fundamental problems:

—Active dollar balances are in the private sector. Most overseas dollar assets are held by international banks and multi-national corporations, and these institutions are more prone to move out of dollars during a period of dollar weakness than are foreign central banks. Indeed, the central banks have become the depository of unwanted dollars from the private sector. A substitution account for official dollar holdings would not necessarily lessen the volatility of dollar assets in private capital markets. Even with a significant substitution of official dollar holdings, there is no assurance that exchange rates will tend to be more stable.⁵

—Despite the recent improvement, there remains some doubt as to whether the SDR is a preferred reserve asset. The IMF has allocated 9.3 billion SDRs to member countries. A quick review of the distribution of these SDRs as of November 1978 suggests that many countries do not wish to hold SDRs. About three-fourths of the IMF members have reduced their SDR holdings. This implies that the SDR has been used as a means of settlement before most alternative reserve assets. In most cases, it appears that central banks have used SDRs before dollar reserves. Given this lack of enthusiasm for SDR holdings, there is a legitimate question of how anxious central banks are to substitute their dollar reserves for SDRs. They already have the option at time of settlement, and few central banks have exercised it.⁶

—Dollar substitution will likely mean increased Federal interest costs. The U.S. Government is a net debtor and foreign central banks hold a third of the total Federal debt as foreign exchange reserves. Any substitution scheme which attempts to replace dollar reserves with SDRs will probably mean that the U.S. will have to assume the cost of bearing exchange risk and possibly higher dollar interest payments.⁷

Specific IMF Proposals

The ideas presented by the IMF staff appear, on first glance, to promise only marginal benefits to the international monetary system and could be costly for the U.S.⁸

The IMF staff outlined three possible forms of substitution accounts:

A. SDR denominated claims issued by the United States.

Under this proposal, foreign dollar holders (presumably official, but this might, in certain circumstances, be broadened to include private) could deposit their dollars in an IMF account in exchange for SDR obligations issued by the U.S.

It appears that new SDR-denominated obligations (bonds) would be nothing other than illiquid assets which would have to be liquidated for other assets at the time of settlement—hardly an international asset used as a medium of exchange between central banks. Such a procedure would not necessarily enhance the reserve role of the SDR. It would only enhance the SDR as a unit of account in determining the obligations a debtor (the U.S.) has to its creditors (former holders of dollars).

If private dollar holders were allowed to use the IMF account to obtain SDR-denominated securities, there might be a reduction in the size of the dollar overhang and possibly more exchange rate stability.

In 1974–75, Chase Manhattan Bank offered SDR denominated certificates of deposits (CDs) to provide international creditors with protection from further dollar decline. The SDR denominated CDs did not prove popular because of the low rate of return on the SDR CDs which Chase felt necessary to offer in order to cover its exchange risk. This experience suggests that the USG may have to pay an interest premium to induce foreign dollar holders to exchange their dollar assets for SDR obligations.

B. Allocation of SDRs by the IMF.

This proposal is to establish an account which would receive dollar deposits from member countries in proportion to their quotas and in exchange for a new SDR allocation. The new SDR allocation would be equal to the “desired” amount of dollars to be absorbed. Furthermore, the U.S. could sell its SDR allocation for unwanted dollars. The dollars exchanged for the newly created SDRs would be kept by the IMF in non-transferable long-term claims against the United States.

This proposal is essentially the mechanism presented last year by the IMF. The approach presupposes that most IMF countries are anxious to exchange their dollar holdings for new SDRs. This may not be the case unless SDRs are no longer regarded as inferior assets.

C. SDR Denominated Claims Issued Through an Account Administered by the IMF.

This proposal would establish an account which would accept an unspecified amount of dollars in exchange for SDR denominated claims on a voluntary basis. The Fund-held dollar assets would, over the long-run, have to equal or exceed the value of SDR claims to cover the Fund’s exchange risk. This implies that the interest earned on USG securities purchased with the dollars deposited in the account would be higher over time than the interest paid to the holders of SDR denominated claims. This approach would provide a safe haven for “excessive”bank officials will consider these SDR claims as preferred assets.⁹

1. Source: National Archives, RG 59, Office of the Under Secretary for Economic Affairs, 1978–1980 Files Pertaining to International Monetary Affairs, OECD, Documents, External Research, Etc., Lot 81D145, Box 2, IMG—International Monetary Group. Limited Official Use. Drafted by John Lefgren (EB/IFD/OMA) and cleared by Michael Ely and William Milam, Director and Deputy Director of the Office of Monetary Affairs (EB/IFD/OMA).
2. No record of the meeting was found.
3. For Cross’ memorandum, see Document 194. Regarding IMF staff paper SM/79/30, January 29, see footnote 4 thereto.
4. The program of international monetary reform adopted by the IMF Interim Committee in January 1976 resulted in amendments being made to the IMF Articles of Agreement; see Foreign Relations, 1969–1976, vol. XXXI, Foreign Economic Policy, 1973–1976, Documents 128 and 129.
5. In a February 8 memorandum to Cooper, his Special Assistant, Peter Clark, suggested that “if one supports a SA” on the basis of its potential contribution to stability in the foreign exchange market, “then one should have evidence that central bank (as opposed to private sector) shifts from dollars to other currencies have contributed to exchange market instability. If this could be established, it would then be necessary to show that a SA would in fact reduce destabilizing portfolio shifts by central banks and monetary authorities.” (National Archives, RG 59, Office of the Under Secretary for Economic Affairs, 1978–1980 Files Pertaining to International Monetary Affairs, OECD, Documents, External Research, Etc., Lot 81D145, Box 2, IMG—International Monetary Group)
6. In his February 8 memorandum to Cooper (see footnote 5 above), Clark commented on the notion that a substitution account would bolster the SDR’s role in the international monetary system: “Assuming that this is a desirable, it is not clear that a SA by itself will achieve this objective. As Hormats’ memo points out, it appears that the SDR is not the preferred asset in central bank portfolios. Mandating substitution or allowing SDR–dollar conversion is unlikely to raise the status of the SDR if its main features, e.g. rate of return, make it unattractive. ”
7. In his February 8 memorandum to Cooper (see footnote 5 above), Clark noted regarding the idea that a substitution account “should (probably) not involve increased costs for the U.S.”: “If the U.S. provides some kind of exchange rate guarantee by taking on an SDR-denominated liability, then clearly the interest rate we pay on this liability should reflect this. The Hormats memo (top of p. 3) is not clear on this point, since it implies that the U.S. might have to bear exchange risk and pay a higher dollar interest rate. Such a combination would clearly be unacceptable.”
8. In his February 8 memorandum to Cooper (see footnote 5 above), Clark suggested that a substitution account “must be considered in a wider context of the future evolution of the international monetary system,” involving consideration of issues including “a) the role of reserve currencies as such, b) the natural tendency for central banks to diversify their portfolio of reserve assets out of dollars into appreciating currencies over the long run and c) the extent to which central banks should be permitted to behave as private portfolio managers and the extent to which their behavior should be constrained in order to achieve benefits for the entire system.”
9. In March 1979, de Larosière submitted a more detailed version of this proposal to the Interim Committee, one in which the “account would convert its assets into longer-term dollar-denominated claims on the U.S. Treasury, which would pay a suitably long-term interest rate on them. Interest would be paid to depositors at the official SDR interest rate (which at the time was maintained below the market rate). The intention was that the account’s exchange risk would be covered by the difference between the long-term U.S. bond rate and the official SDR interest rate.” The Interim Committee, in turn, indicated its “broad support” for active consideration of such an account. (Boughton, Silent Revolution, p. 939)