BIS Papers No 58 165The role of SDR-denominated securities in official and private portfolios George Hoguet and Solomon Tadesse1 1. Introduction This paper examines the role that securities denominated in special drawing rights (SDRs) could play in the management of large institutional portfolios. We find such securities could reduce portfolio variance and could provide a convenient method of diversification. While a nascent market for SDR-denominated bonds began in the early 1980s, it did not develop and remained very small relative to global bond issuance. Yet Chinas recent call to expand the use of the SDR could provide the impetus for a renewed effort to use the SDR as a unit of account for short-term deposits and fixed income obligations. Chinas initiative has been supported by Russia and Brazil, among others. In light of the comments by some of their sponsor governments, sovereign wealth funds (SWFs) and highly diversified monetary authorities (central banks that acquire risk assets) are well-positioned to promote the development of a market for certificates of deposit and bonds denominated in SDRs. While several technical issues like liquidity provision remain to be resolved, the evolution of the European Currency Unit (ECU) bond market provides some evidence that a market in SDR-denominated bonds could develop. Although ECU-denominated bonds at their peak never accounted for more than 10 percent of the issuance of all international bonds (Dammers and McCauley 2006), as with SDRs, both a private and official market for ECUs existed. An investor can synthetically replicate the weights of an SDR-denominated bond, but a security denominated in SDRs is self-rebalancing and is likely to minimize rebalancing costs. Additional research, particularly on the coordination problem (which limits liquidity) and operational issues, including settlement, can facilitate the development of an SDR-denominated bond market. Williamson (2009a) suggests that greater private use of the SDR could possibly facilitate greater official use, including the pegging of currencies to the SDR rather than to a basket of currencies or to some bilateral exchange rate. It is important for investors to understand the distinction between “private” SDRs, in which the SDR serves as a unit of account, and “official” SDRs, which are official reserve assets. In this paper, we focus on the use of the private SDR as a unit of account. However, as the private SDR relies on the portfolio composition and value of the official SDR, we will first briefly discuss the official SDR. 1 Hoguet is Managing Director, State Street Global Advisors, One Lincoln Street, Boston, MA 02110, tel: +1-617-664-2487, fax: +1-617-664-5960, e-mail: George_HoguetSSgA.com. Tadesse is Vice President, State Street Global Advisors, One Lincoln Street, Boston, MA 02110, tel: +1-617-664-1539, fax: +1-617-664-5960, e-mail: Solomon_TadesseSSgA.com. The authors thank Warren Coats and Mark Hooker for their helpful comments. The views expressed in this paper are those of the authors only, and should not be interpreted as reflecting the views of State Street Global Advisors. 166 BIS Papers No 582. Background The most severe financial crisis since the Great Depression has led to massive global policy interventions and renewed calls to re-examine the global financial architecture. In addition, some holders of U.S. Treasury bills and bonds have become concerned about potential losses on their holdings. For example, in March 2009 Chinese Premier Wen Jiabao stated that: “We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little bit worried.”2 He reiterated his concerns the following month at the Boao Forum for Asia. Further, in March 2009, the Peoples Bank of China (PBOC) posted a speech by Governor Zhou Xiaochuan entitled “Reform the International Monetary System.” Among other initiatives, Zhou emphasized: 1. Reforming the international monetary system and creating an international reserve currency that “is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies” (p.1, Sec II). 2. Entrusting part of member countries reserves to the centralized management of the International Monetary Fund (IMF). 3. Expanding the use of the IMFs SDRs, including as a means of payment, currency of denomination of securities, commodity denomination and reserve currency. 4. Expanding the basket of currencies forming the basis for SDR valuation to include currencies of all major economies, and including GDP as a factor in currency selection for the SDR. China currently holds approximately $2.2 trillion in gold and foreign exchange reserves and about $800 billion in U.S. Treasuries, as well as an estimated $500 billion in U.S. Agency debt. The rapid