Upon A Shaky Foundation... Enter Covid-19

And so castles made of sand fall in the sea, eventually.
– Jimi Hendrix

There's a widespread belief out there that the U.S. and the global economy in general is on much sounder footing ever since the financial crisis of a decade ago. Unfortunately, this false assumption has resulted in widespread complacency and elevated levels of systemic risk as we enter the early part of the 2020s.

All it takes is a cursory amount of research to discover nothing was "reset" or fixed by the government and central bank response to that crisis. Rather, the entire response was just a gigantic coverup of the crimes and irresponsible behavior that occurred, coupled with a bailout designed to enrich and empower those who needed and deserved it least.

Everything was papered over in order to resuscitate a failed paradigm without reforming anything. Since it was all about pretending nothing was structurally wrong with the system, the response was to build more castles of sand on top of old ones that had unceremoniously crumbled. The whole event was a huge warning sign and opportunity to change course, but it was completely ignored. Enter novel coronavirus.

I've been concerned about the coronavirus outbreak from the start, and have been tweeting about it consistently for well over a month.

We have no idea what's actually happening with this thing, yet planes are landing from China all over the world. We may very well avoid a global disaster here, but if we do it'll be because of luck.

— Michael Krieger (@LibertyBlitz) January 27, 2020

This observation proved prescient within just a few weeks, as the U.S. Centers for Disease Control (CDC) screwed up its early response to the pandemic in the most sloppy and unimaginable way possible. For whatever reason, the CDC instituted ridiculously stringent guidelines for testing potential infections by limiting testing to only those who recently traveled from China or had contact with someone known to be infected. The CDC continued to stick to these insane guidelines as the disease began to spread rapidly all over the world, particularly in South Korea and Italy.

The event that finally prompted the CDC to change its guidelines was the emergence of the first confirmed incidence of community spread coronavirus in the U.S., which occurred in northern California. The health professionals caring for that patient had requested testing days earlier, but the CDC rejected the initial request, putting medical staff and others at risk for no good reason. On top of all that, the limited testing kits the CDC had sent out didn't work properly. The level of incompetence and failure we've seen from the CDC is almost hard to fathom, but given how hollowed out and corrupt our society has become, shouldn't be surprising.

At this point, nobody knows what the eventual impact of the coronavirus on the planet will be. Anyone who says they know for sure is lying, but I think we should be taking it very seriously given the potential tail risks. A global pandemic is an uncertain and dangerous thing in the most robust and healthy of systems, but the consequences within a fragile house of cards system such as ours can be devastating.

A month ago, stock market valuations were near the highest ever and interest rates were near the lowest they've been in recorded human history. A gigantic "everything bubble" of historic proportions had been blown and investors were flying too close to the sun. It was a balloon looking for a pin, and it found one in the coronavirus. Nobody knew what the pin would be, which is exactly why the stock market collapsed so rapidly the moment investors began to appreciate the gravity of the situation. The fragility of the financial markets should be taken as a warning sign with regard to the rest of the system.

Financial assets have been intentionally blown to nonsensical levels in order to coverup the massive rot underneath. They've been masking the fact that much of the underlying economy consists of little more than financial engineering scams and war-making enterprises. The imperial oligarchy we live under is an utterly rotten, corrupt, and fragile superstructure that's been carefully hidden for ten years under a facade of euphoric markets and a mass of debt-based consumption slaves.

The coronavirus itself should be seen in this context. The global system as it exists is simply not prepared for anything like this, but the reality is things like this do occur from time to time. Maybe we'll get lucky and avoid the worst case scenario with this virus, but that's not the point. There will always be other pins, and when your entire superstructure is fundamentally fragile and led by mediocre, corrupt sociopaths, it doesn't take much to bring it down faster than you can imagine.

We stand at a moment where the fragility of our Potemkin Village paradigm will increasingly confront the harsh realities of meatspace. Coronavirus is a warning. It's exposing a lot already, and will likely expose far more as it continues to spread. It's exposing our ridiculous financial bubbles, it's exposing the fact the U.S. can't even manufacture its own surgical masks or medicines, and it's exposing the clownish ineptitude of our leaders and institutions.

It's insane that a country with the size and power of the U.S. can't manufacture its own hospital masks, equipment and medicine.

If coronavirus doesn't wake us up to the dangers of a completely hollowed out financialized economy, something else will.

— Michael Krieger (@LibertyBlitz) March 2, 2020

It's important we take this warning to heart and do something useful with it. It's crucial we understand that the current paradigm is long past its useful life and likely won't be hanging around much longer. Don't cry or experience nostalgia for what was, rather, get your stuff together so you can help build and usher in the new world to come.

Those too attached to the way things have been will have a particularly hard time adjusting to the turbulent times ahead, so you want to do whatever you can in order to avoid being in that group. Change doesn't have to be bad, but resistance to change can be deadly. Don't allow yourself to be a casualty.

"It Smells Like Panic": This Is Not What Powell Had In Mind...

Commenting on the Fed's emergency rate cut, which while expected was extremely unusual and only the first one since the financial crisis, Obama's chief economic advisor Larry Summers laid out the problem Powell is facing, especially now that the Fed appears to have lost much of its remaining credibility:

Fed Risks 'Scaring People' With Rate Cut. My interview today on the Fed's emergency rate-cut on @BloombergTV.

When you have limited ammunition you have to conserve it. The Fed has limited ammunition with interest rates so low.  Interest rates don't cure the #coronovarius and interest rates don't repair supply chains.

While Larry Summers' opinion has been repeatedly discredited over the years, he does bring up a valid point: why is the Fed wasting half of all of its ammo just to delay what is now an inevitable crash, and why scramble with an "intermeeting" cut when it could have jawboned for the next two weeks and waited until the regular March 18 FOMC meeting. If anything, it would at least eliminate the sense of Fed panic from the equation.

Instead, as it stands "it smells like panic" as more than one Wall Street veteran put it.

Worse, as BMO's Ian Lyngen puts it, what happened after the Fed's emergency 50bps rate cut, the biggest since Jerome Kerviel blew up SocGen, "the situation didn't play out exactly as Powell might have envisioned."

So just how bad is it? Well, as plunging stocks demonstrate, the Fed is this close from losing all credibility.... and since the market has been held up for the past 11 years on nothing but Fed faith - and trillions in Fed liquidity - this could be a very, very big problem.

Lyngen explains:

The Fed's emergency 50 bp rate cut brought 10-year yields to fresh record lows and a 0-handle was realized. To a
great extent, we'll argue the situation didn't play out exactly as Powell might have envisioned. It's doubtful that
when JP left home this morning he thought '50 bp will really crush the stock market.' So it goes.

The precipitous slide in equities was the driver behind the ease to begin with – as the spike in equity vol translated to tighter financial conditions via this now well-traveled path. This is where it becomes problematic; while stocks initially rallied on the 'good news' of rate cuts, the optimism quickly faded as the intermeeting nature of the move raised more questions than it answered. On one hand, the Fed is willing to be proactive but on the other, how much more will rates ultimately need to be cut?

If the FOMC wanted this exercise to be a 'one-and-done' event, that message wasn't correctly communicated to the futures market which presently has roughly 60% odds of another move in two short weeks priced in. Admittedly, the 100% probability for the next cut being a quarter-point is worth a nod. Given the way in which risk markets are responding to today's half-point, it's challenging to imagine a 25 bp move would be met by the warm risk-on embrace to which monetary policymakers have become accustomed. We'll stop shy of labeling it a 'face-in-hand' day for the Fed; if nothing else the question of whether or not just 50 bp would suffice has been answered… hint: it was 'no'.

The biggest risk was always that by acting too proactively and aggressively Powell would signal that the situation is worse than initially feared. Check.

With 10-year yields on a slippery slope to 75 bp (there, we said it) and 2s conceivably poised to touch 50 bp, it's somewhat concerning that the 2s/10s curve hasn't steepened out any more – 34.5 bp remains the line in the sand. The rationale for the reluctance to steepen is sound; lower rates cannot cure the coronavirus and are unlikely to fully offset the hit to consumption, confidence, and inflation. As a result, the accommodation only creates a muted inflationary impulse.

It gets worse:

In two short weeks the Committee will be faced with a very difficult decision of either underwhelming investors' expectations or quickly utilizing the limited rate-cutting potential afforded by the low outright yield environment.

Once the effective lower-bound is established, expanding the balance sheet will become topical and if risk sentiment isn't restored by dropping rates, the next tool in the policy box will be expanding the balance sheet. As the Fed determines the next installment of accommodation, the signaling power for responding to Tuesday's stock selloff will undoubtedly be a consideration; after all, the takeaway from the first 50 bp was that another will quickly follow and there is information held at the Fed which investors can only utilize by following the lead of central bankers.

Said differently, if Powell's nervous, perhaps we all should be. At least that was the sentiment behind the flight-to-quality that brought 10-year yields to just 89 bp intraday.

China Composite PMI Crashes To Record Lows As Services Economy

Stagnating consumption amid the coronavirus epidemic has had a great impact on China's service sector in February, as one would expect.

February PMI data signalled the first reduction in business activity across China's service sector on record due to restrictions implemented to contain the recent coronavirus outbreak. Firms across all sectors reported on the damaging effect that the virus was having on the economy via company closures and travel restrictions, with total new orders also falling at a record pace. Restrictions around travel also impacted firms' ability to source workers, leading a renewed fall in staff numbers. Consequently, backlogs of work rose at a substantial pace.

Commenting on the China General Services and Composite PMI data, Dr. Zhengsheng Zhong, Chairman and Chief Economist at CEBM Group said:

"The Caixin China General Services Business Activity Index fell to 26.5 in February, about half the reading of the previous month, marking its first drop into contractionary territory since the survey launched in November 2005. Stagnating consumption amid the coronavirus epidemic has had a great impact on the service sector.

1) Demand for services shrank sharply. Both the gauges for total new business and new export business dropped to their lowest levels on record.

2) It was difficult for service providers to recruit workers, and backlogs of work climbed. The drop in the employment gauge was relatively small, but its February reading marked the lowest point on record. The measure for outstanding orders surged to a record high. Supply capacity across the service sector was insufficient amid restrictions on the movement of people.

3) The measure for input costs dropped at a steeper rate than that for prices companies charged customers, because of a sharp decline in supply capacity.

4) Business confidence also fell to a record low. Although policies have been introduced to provide tax and financing support for industries and small businesses heavily impacted by the epidemic, service companies were still concerned about uncertainties resulting from the epidemic.

In sum, Goldman concludes that the Caixin and NBS PMI surveys suggest activity growth in February was extremely weak. We expect service activity to partially recover in March, but in absolute level, it might take longer for services activities to normalize than manufacturing activities.

Additionally, the Composite Output Index signaled the sharpest decline in total Chinese business activity on record in February, as company closures and travel restrictions were put in place due to the coronavirus outbreak.

"The Caixin China Composite Output Index dropped to 27.5 in February from 51.9 in the previous month. While the gauges for new orders, new export orders and employment all weakened to their lowest levels on record, the gauge for backlogs of work rose to a record high. The decline in input costs was greater than that in output prices because upstream industries' supply capacity was less affected.

"The coronavirus epidemic has obviously impacted China's economy. It is necessary to pay attention to the divergence of business sentiment between the manufacturing and the service sectors. While recent supportive policies for manufacturing, small businesses and industries heavily affected by the epidemic have had a more obvious effect on the manufacturing sector, it is more difficult for service companies to make up their cash flow losses."

And as China's Composite PMI collapses, US and Japan are also in contraction with Europe - for now - somehow managing to cling to expansion...

But the funniest thing of all is the fact that Chinese stocks are dramatically outperfoming US and European since the start of the crisis...

Thanks National Team for making it all seem awesome!

"Ground Zero For Trade" – Port Of Long Beach Warns Of Shipping Slump From China

Investors are grossly underestimating the potential economic impact of Covid-19 as the first signs of China's supply chain meltdown are now washing ashore on US West Coast ports. 

The Port of Long Beach, the second-largest containerized port in the US, has had two top officials warn in the last several weeks of chilling effects of supply chain disruptions from China. 

Last week, the Deputy Executive Director of Administration and Operations for the Port of Long Beach Noel Hacegaba warned China's economic paralysis led to the increase of blank sails between China and the US. He said port activity plunged in January and February, with expected weakness to continue through March.  

Hacegaba said the slowdown at Long Beach is starting to hit the local economy around the port. He said it could only be a matter of time before it triggers a broader slowdown in the region, and even maybe in the overall US economy. 

As we've noted in many pieces of creaking global supply chains fast emerging in China and spreading outwards, Deutsche Bank's senior European economist Clemente Delucia last month pointed out in a report titled "The impact of the coronavirus: A supply-chain analysis" that the US is overly exposed to a crashing China economy.

As for the second Long Beach official, Bloomberg quoted Mario Cordero, executive director of the port, who said cargo volumes are expected to slump 9% YoY in February due to declining shipments from China.

Cordero said February's YoY loss is nearly double of 2019's decline of 5.4%, which has already resulted in a 50% reduction in labor at the port. He said the East Asia shipping route accounts for 90% of shipments through the port. 

"The port of Long Beach is ground zero for trade," warns Cordero. "There was uncertainty with the trade war, but the coronavirus has taken it to chaotic."

Downward pressure from supply chain disruptions in China has now spilled over into the rest of the world. The transmission mechanism to the US is West Coast ports. The port Long Beach handles $200 billion in trade annually and supports 2.6 million trade-related jobs across the country, including almost 600,000 in Southern California.

As for other West Coast ports, reports of a containerized volume declines from China are inevitable. These ports are a critical artery of the US economy's transportation infrastructure and essential for the flow of imports and exports, representing about 12.5% of US GDP. 

A slowdown of containerized volume at Long Beach and other West Coast ports could suggest a broader economic downturn is ahead for the US economy. 

Tesla Registrations Plunge In Two Crucial European Countries

If Tesla was truly a story about actual economics - you know, things like demand and production - we might expect the fact that registrations are plunging to have an effect on the company's stock price.

But, as it goes, the company's stock is and has been wholly disconnected from reality, which is why at the stock sits currently with a $700 handle, we're certain it won't be phased by the fact that registrations have plunged in top European markets. 

For instance, Tesla recorded only 83 new cars in Norway last month, comparing to 1,016 vehicles last year. In the Netherlands, registrations also plunged, down 68% to 155 units, according to Bloomberg.

It is not a good look for Tesla, as these are two of the only four countries that Tesla breaks out revenue for on a quarterly basis. For the first two months of the year (and first 66% of the first quarter), registrations were down 77% and 42% in Norway and the Netherlands - and that was against easy comps. The Model 3 was only just starting to get underway with sales in early 2019. 

Norway began to saturate last year and the Netherlands saw a favorable tax provision for EV buyers disappear. Revenue from the Netherlands and Norway was up 65% and 48% in 2019, respectively, which helped offset a 15% drop in the U.S. With these key Europeans countries not absorbing the blow any further, what could Tesla's Q1 2020 revenue look like?

Of course, the Tesla "carrot on the string" now turns to Germany. In addition to Tesla building its next Gigafactory there, the country has unveiled a landmark climate related stimulus package. It is offering subsidies to boost EV sales and is expected to overtake Norway as the regional EV leader.

But the falling sales in Europe will make it tough to cushion any blow not only in the U.S., but in China, where coronavirus has ravaged the country and auto sales, in general, are down between 80% and 90% for February. This hasn't stopped Tesla's stock from holding a bid in the $600 to $700 range, even despite the market's recent sell off on coronavirus fears.

For now, the $120 billion cash incinerating company remains in tact.

We can't help but wonder if a further plunge in the markets could reveal any "interesting" information about Tesla and/or its financials going forward. 

What Is An SDR And Will It Be The Next World Reserve Currency?

There's no way IMF's Special Drawing Right, a poorly designed synthetic reserve asset, will replace the U.S. dollar as the world reserve currency.

After several years of monetary madness—artificially lowering interest rates to the extent all asset prices are distorted—the world is slowly waking up to the fact that printing money by central banks is a one-way street. Once central banks enter this trajectory (and they have), they can't reverse. Markets have become addicted to cheap money, and central banks feel compelled to print more when the economy, or stock market, weakens. The Federal Reserve, the issuer of the U.S. dollar, is trapped too. Possibly, a paradigm shift in the international monetary system will transpire during the coming economic downturn, and the dollar will lose its status as the world reserve currency.

Some analysts proclaim the next world reserve currency is standing ready to replace the dollar. This would be the Special Drawing Right (SDR), issued by the International Monetary Fund (IMF). According to my analysis, though, the SDR isn't capable of being the world reserve currency. It will never be much more than a unit of account.

If you ask a random financial expert what an SDR is, he or she is likely to say, "It's a currency issued by the IMF, comprising a basket of the world's most important currencies." Based on this definition, some analyst forecast the SDR will replace the dollar. But, from examining the anatomy of the SDR, it appears it's not a currency and there is no free market to exchange them. Which is problematic.

Introduction

The SDR is a "supplementary international reserve asset" that was created by the International Monetary Fund in 1969. At first, it was defined as 0.888671 grams of gold. By denominating it in a fixed weight of gold, some thought SDRs were backed by gold. Alas, SDRs were created out of thin air and then given a gold exchange rate, but they could not be redeemed for gold.

In 1974, after the collapse of Bretton Woods, the SDR's value was redefined based on a basket of currencies. But, again, the SDR was not backed by these currencies. Rather, the SDR's valuation was, and is, based on the weights given to the currencies in the basket.

On the IMF website, we can read an illuminating definition of the SDR:

The SDR is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members.

The SDR is not a currency, because it can't be used by individuals; it's not a medium of exchange. The word "potential" in the definition of the SDR is crucial. It reveals that any monetary authority holding SDRs, might be able to convert them into "freely usable currencies of IMF members", or it might not. How come? In the IMF Financial Operations 2018 we can read:

there is no market for the SDR itself in which excess supply or demand pressure can be eliminated by adjustments in the price, or value, of the SDR.

The SDR is a "potential claim" on freely usable currencies, because there is no market for the SDR, and it's not a liability of the IMF. The result is that possibly SDRs can be exchanged for actual currencies (below is explained how), but there is no guarantee.

How the SDR can function as the backbone of the international monetary system (IMS) if there is not a (highly liquid) market for it? The answer is, it can't.

From this short introduction, we see that the SDR is essentially a unit of account. In the remainder of this article, we will delve into the anatomy of the SDR, how it's traded and the likelihood of replacing the U.S. dollar.

What Is an SDR?

The SDR is a supplementary international reserve asset. SDRs can't be held by private entities or individuals, but only by IMF member countries, and, currently, fifteen organizations approved by the IMF as "prescribed holders" (page 91). Let's start with a brief introduction of the IMF's governing structure, as a backdrop to understand how SDRs are created and used. We'll start with the IMF's General Department.

Courtesy IMF Financial Operations 2018.

The IMF's resources are mainly held in its General Resources Account, which is managed by the General Department. Each IMF member country is required to transfer financial resources to the IMF based on its "quota", set according to a member's relative economic position in the world economy. The General Resources Account is a pool of currencies and reserve assets, mostly built from members' paid capital subscriptions derived from quotas (page 13).

Courtesy IMF Financial Operations 2018.

For lending operations (for which the Fund is mostly known for), the IMF does offer SDRs as an alternative to "usable currencies" from its General Resources Account, but in practice, the majority of loans and repayments are made in usable currencies (page 92). ("Freely usable currencies", according to the IMF are currencies "widely used to make payments for international transactions, and [are] widely traded in the principal exchange markets.")

Quotas are also tied to an IMF member's voting power, and they determine the share of SDR allocations. When SDR's are created by the IMF, out of thin air, they are allocated among all 189 IMF members according to the quotas. The IMF can't allocate SDRs to itself or to prescribed holders (page 89).

Once newly created SDRs are collected, two entries arise on an IMF member's balance sheet: "SDR holdings" on the asset side, and "SDR allocations" on the liability side.

Courtesy Users' Guide To The SDR: A Manual of Transactions and Operations in SDRs.

Members receive the SDR interest rate on SDR holdings and pay the SDR interest rate on SDR allocations. SDR interest rate transfer system is a zero-sum game. Those having less SDR holdings than allocations pay interest to those with more SDR holdings than allocations. The IMF's SDR Department, the center of the SDR apparatus, manages all interest rate flows.

So when, say, Norway exchanges SDR holdings for currency via the IMF's SDR Department, Norway's SDR holdings will be lower relative to its SDR allocations. Therefore, Norway will pay interest. Norway's transaction will cause others, in the SDR universe, to have more SDR holdings than allocations who then will receive the interest paid by Norway.

The SDR department receives interest on all outstanding SDR holdings and charges interest on all SDR allocations.

How Is the SDR Value and SDR Interest Rate Determined?

The exchange rate of the SDR, set daily, is based on the weights of the currencies comprising the SDR basket. Today, the basket contains five currencies: the U.S. dollar, Chinese renminbi, the Japanese yen, the euro, and the Great British Pound. In the second column in the table below, you can see what weight, in percentage, is assigned to each currency ("Currency weight").

The SDR is revised every five years. The most recent revision of the SDR basket was in 2015, when the Chinese renminbi was added. After the revision, on October 1, 2016, the new currency weights were set, and the exchange rates between the currencies that day prompted a "Currency amount" for each of them (page 100). The latter is displayed in the third column in the table above and can be seen as a multiplying factor for the SDR's daily valuation.

Because the exchange rates between the currencies in the SDR basket continuously fluctuate, prevailing rates are used for the SDR's daily valuation as well. In the fourth column, you can see the prevailing "Exchange rate," which is multiplied by the currency amount to arrive at a "U.S. dollar equivalent" (in the fifth column). All the U.S. dollar equivalents added up instigate the price of the SDR denominated in U.S. dollars. On February 14, 2020, the value of the SDR was expressed as $1.36751. With the U.S. dollar exchange rate, the SDR's exchange rate with other currencies can be computed.

So, the SDR is neither a claim on these currencies nor do they fully or fractionally back the SDR. Instead, the currency weights, currency amounts, and exchange rates produce a daily SDR value, which is used when SDRs are exchanged for currency.

The SDR interest rate is set weekly and is based on the 3-months interest rate benchmarks of the five currencies and their respective weights in the SDR basket (page 89). The interest rate benchmarks are:

—US dollar: three-month US Treasury bills

—Euro: three-month rate for euro area central government bonds with a rating of AA and above published by the European Central Bank

—Chinese renminbi: three-month benchmark yield for China Treasury bonds as published by the China Central Depository and Clearing Co. Ltd.

—Japanese yen: three-month Japanese Treasury discount bills

—Pound sterling: three-month UK Treasury bills.

Remarkably, the floor for the SDR interest rate is 0.05%.

How Are SDRs Traded?

Because "there is no market for the SDR itself in which excess supply or demand pressure can be eliminated by adjustments in the price", SDRs are primarily traded via Voluntary Trading Arrangements (VTAs). Meaning, supply and demand are connected through a managed market at the SDR Department. In the IMF Financial Operations 2018, we read:

The role of the IMF [SDR Department] in transactions by agreement [VTAs] is to act as an intermediary, matching participants in this managed market in a manner that meets, to the greatest extent possible, the requirements and preferences of buyers and sellers of SDRs.

In other words, a country wishing to sell SDRs for usable currency will notify the SDR Department to match the seller with a buyer. Trades are settled through the SDR Department. It's not prohibited for countries to exchange SDRs for currency, but, again, there's no market. The SDR is used almost exclusively in transactions with the IMF; for operations between IMF members and the General Resources Account (page 86).

Next to VTAs through the SDR Department, there's one more way for the IMF to make its members exchange SDRs: the designation mechanism. From the IMF Financial Operations 2018:

In the event there is insufficient capacity under the voluntary trading arrangements [VTAs], the IMF can activate the designation mechanism: IMF members with a strong balance of payments and reserves position may be designated by the IMF to purchase SDRs from members with weak external positions.

In case of emergency, the IMF will designate a member, with a strong balance of payments, to exchange currency for SDRs (page 105). Although, I doubt the designation mechanism has ever been activated, or ever will (page 86 and 93). The IMF states, "the functioning of the SDR Department … is based on the principle of mutuality and intergovernmental cooperation." As far as I know, there is no judicial framework that can make the IMF command sovereign nations how to disperse their international reserves. In case the proverbial "shit hits the fan", I'm doubtful members will buy SDRs according to the whims of the IMF.

With respect to IMF loans, things are different. These are based on conditionality, in which case the Fund can exercise significant power over borrowing nations.

Other Deficiencies

According to my analysis, the SDR will never be the main international reserve asset. Not in its current form, nor in any future form. One of its deficiencies that I haven't addressed extensively is that the essence of the SDR has changed regularly since 1969. First, it was a book entry defined in gold weight. In 1974 its value was redefined as a basket of sixteen currencies. And the SDR interest rate "set semiannually at about half the level of a combined market interest rate that was defined as a weighted average of interest rates on short-term market instruments in France, Germany, Japan, the United Kingdom, and the United States [page 87]." In 1981 the basket was altered to five currencies, and the SDR interest rate was made equal to market rates. In 2000, the basket was brought down to four currencies, and new selection criteria were adopted. In 2015, the last significant change was made when they added the Chinese renminbi. But who knows what an SDR will be in the future?

Now, why would any monetary authority hold most of its resources in an asset which essence can be modified (and its units created boundlessly)? And then to think there is no actual market for them to be exchanged, and Voluntary Trading Arrangements and the designation mechanism presage anything but liquidity.

What Have SDR Scholars Written?

Another core deficiency of the SDR was addressed by Eswar S. Prasad, former Chief of the Financial Studies Division at the IMF's Research Department, in The Dollar Trap (page 280):

In principle, SDRs can be exchanged for "freely usable" currencies but cannot be used directly in private transactions. Thus, increasing the stock of SDRs does not increase the total liquidity of the global monetary system.

Because SDRs are not backed by anything and are not a medium of exchange, creating SDRs doesn't create more "total liquidity of the global monetary system."

Now, what is the true value of these SDRs as they're not backed by currency and there is no market to exchange them? The reality is that the SDR's true value "derives from the commitments of members to exchange SDRs for freely usable currencies [page 86]." Consequently, when members aren't committed to exchange SDRs, its true value drops to zero. Surely, a fictional exchange rate will continue to be published—to serve as a unit of account—but its true exchange rate would be zero.

The economist Fred Hirsch, senior adviser to the IMF (1966-1972), published an essay in 1974 titled "An SDR Standard: Impetus, Elements, and Impediments." Hirsch wrote that it was "generally recognized in both academic and official circles, [that] SDRs in their present form are inadequate … [as] a secure and controlled base for world monetary reserves." To continue, "a more comprehensive SDR system would represent a substantial step toward a world central bank."

I agree. Maybe the SDR can succeed if its essence is changed once again, the world would fully financially integrate, and all countries would be subordinate to one world central bank that could control all of its members' monetary policy. But that's not going to happen. First, it makes no sense. Second, the current trend is financial disintegration. Look at Brexit and the trade war between China and the U.S. Are we really to believe that the world will submit under a new global central bank that will issue the "SDR 11.3.4"? And all nations will surrender their monetary sovereignty? I don't think so.

Additionally, central banks are buying gold or repatriating gold. The motivation to buy gold is to diversify away from what can be printed boundlessly. Repatriating gold was called "economic nationalism" by the Executive Director of the Austrian central bank in 2015, Peter Mooslechner. Which is a fitting description for the present trend.

Hirsch also stated integration wasn't feasible, nor, in his view, desirable:

At present [1974], however, the integrationist objective is not generally regarded as feasible on a global basis (and some, including myself, would not regard it as desirable).

Why China Is Promoting SDRs

Some of you might think, "so what was all the fuss about when the renminbi was added to the SDR? Financial blogs were speaking of a new paradigm! What about the Governor of the People's Bank of China (PBoC), Zhou Xiaochuan's paper from March 23, 2009—Reform the international monetary system—in which the SDR was discussed?"

Yes, Zhou wrote the IMS should be less centered around the U.S. dollar, and more towards, as an example, the SDR. From Zhou about the SDR:

A super-sovereign reserve currency managed by a global institution could be used to both create and control the global liquidity.

Special consideration should be given to giving the SDR a greater role.

This will require political cooperation among member countries.

Zhou's remarks boil down to an SDR overhaul and a world central bank, as mentioned by Hirsch. Not feasible.

In my view, Zhou mentioned the SDR as a decoy. There are two reasons why the Chinese like to talk about SDRs.

One, the SDR is about symbolism. China's goals are to internationalize the renminbi as a trade currency, and have it globally accepted as a reserve currency. In the end, to leverage the Chinese economy, equal to the extent economies of international currency issuers such as the U.S. and the eurozone have advantaged. Adoption into the SDR gave the renminbi a seal of approval as world reserve currency. This is one reason why China is cheering about the SDR.

Two, the Chinese want to diminish the role of the U.S. dollar in every way possible. Hence, China currently publishes its international reserves denominated in U.S. dollars and SDRs. For the Chinese, the more attention is diverted from U.S. units of account, the better.

China's international reserves in 2019, denominated in U.S. dollars and SDRs.

In 2016, the weight of the Chinese golden Panda coin changed from 1 troy ounce to 30 grams. Effectively, the coin's weight went from 31.103 grams to 30 grams. This change was symbolic as well as strategic: to use as few U.S. units of account as possible. Similar to denominate value as much as possible, "not in U.S. dollars." The Panda weight adjustment also streamlined it to be traded on the Shanghai Gold Exchange, where the gold price is quoted in yuan per fine gram (not troy ounce).

Next to symbolism, China also develops concrete methods to gain international market share at U.S.'s expense. By, for example, launching international commodity trading in renminbi such as the Shanghai Gold benchmark and Shanghai Oil.

Consider that since Zhou's paper was published, in March 23, 2009, the PBoC added 520 million SDRs to its international reserves and 1,348 tonnes of gold. Measured in their own units of account (irrespective of the change in the gold price), China's SDR reserves went up by 95%, and its gold reserves by 225%.

But because a unit of gold is more expensive, and its price has gone up since 2009, the amount of gold added by the PBoC since then is worth 50 billion SDRs at today's prices, which is 9,491% more than the 50 million in SDR reserves increment.

Did Zhou mean to shift the IMS towards the SDR? Did he saw value in the SDR? If so, why didn't he put his money where his mouth is?

Or, was Zhou's message simply to ditch the dollar, but he preferred not to speak about gold, as this would put steroids on the gold price? An escalating gold price would make the PBoC able to buy less gold in the process of diversifying its foreign exchange reserves. I think this is why Zhou mentioned SDRs.

It's always best to look at what central bankers do, not what they say. Across the globe many central banks have been shifting towards gold since 2009, not SDRs.

Conclusion

From all the deficiencies concerning the SDR—it's not a currency, there is no market, no liquidity, it's essence can be changed, etc.—I think the SDR will continue to play a marginal role in international economics. At most its use as a unit of account will be expanded.

In the near future I expect gold's role in the IMS to increase. When economic growth declines, countries will (likely) devalue their currencies, and when "economic nationalism" increases, reserve asset managers will prefer to hold the only universally accepted financial assets that doesn't have counterparty risk and can't be printed: gold.