Comment on “Reforming the international monetary system in the 1970s and 2000s: would an SDR substitution account have worked” by Robert McCauley and Catherine Schenk Dong HE ( 何東 ) Executive Director (Research), Hong Kong Monetary Authority Director, Hong Kong Institute for Monetary Research Conference on The BRICS & Asia, Currency Internationalization, and International Monetary Reform Hong Kong, December 2012

2 What does the paper do?  An archive based account of the political economy of the SDR Substitution Account proposal  Simulations of the solvency of the Account using historical observations of SDR interest rates and US treasury yields of bills, notes and bonds  Present a somewhat “skeptical” view on the proposal, in contrast to Kenen, Bergsten, and others

3 A quibble  A more comprehensive simulation exercise would call for a stochastic approach, deriving a probability distribution of the solvency of the Account  A stochastic simulation would make issues such as the initial conditions (e.g., the start date of the Account) less a problem in assessing the feasibility/sustainability of the Account

4 Broader and more fundamental questions  What is the nature of reserve currency issuance? Does the “Triffin Dilemma” generally hold?  What does that tell about the future of the SDR as a global reserve asset?  In principle, what would make an SDR substitution account work?

5 The nature of reserve currency issuance  A reserve currency country plays the role of a bank to the rest of the world: it provides a liquidity service by issuing short-term liabilities that non-residents would use for international trade and investment  But to prevent this process from becoming a Ponzi scheme, it also needs to invest in other countries, perhaps in less liquid forms and with longer maturity, such as foreign direct investments  In other words, issuing reserve currency is a process of financial intermediation through the international balance sheet of the reserve currency country

6 The Triffin Dilemma  In its original and narrow sense, the Triffin Dilemma points to a potentially explosive path of reserve currency issuance: short-term liabilities of the reserve issuing country grows infinitely against the backing of a stagnant stock of gold. This would cause a run on the currency, particularly if the short- term liabilities were caused by current account deficits  A main problem with Triffin’s arguments was that he ignored other assets that the United States had on its international balance sheet, i.e. its claims against non-residents, which were making good returns to finance its short-term liabilities  In a broader perspective, the Triffin Dilemma points to an inherent conflict: domestic policy objectives of the major reserve currency country overrides its obligations to maintain global monetary and financial stability

7 Implications for the SDR?  The issuance of SDR, which has to be of a much larger scale than ever envisaged to be a meaningful global reserve asset, needs to be backed by yield-enhancing claims on the asset side of the balance sheet  The SDR issuance process needs to be a maturity transformation process  In other words, the SDR issuer has to become more like a bank or a credit union  It is thus not surprising that McCauley and Schenk find that “basing the Treasury’s dollar interest payments to the Substitution Account on the 20-year bond yield would have done wonders for the solvency of the scheme”

8 Would an SDR substitution account in principle work?  Yes, if such an account is managed actively and professionally as a mutual fund  The yield on the SDR liabilities may need to be contingent on the performance of the fund  But this would still serve the original purpose of the substitution account: a diversification from the risk of a persistent depreciation of the US dollar

End of discussion Thank you for your attention!