The IMF's special drawing rights alone are no silver bullet for needed climate finance

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Maurice Obstfeld (PIIE)and Edwin M. Truman (PIIE)

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Photo Credit: ULAN/Pool/Latin America News Agency via Reuters Connect

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Low- and middle-income countries need more resources to meet the costs of mitigating and adapting to climate change. The entire global community favors such assistance in principle, but concrete supportive action by high-income countries has lagged behind promises. Some commentators, including influential economists, think that they have found a silver bullet: the special drawing right (SDR), an international reserve asset created in 1969 by the International Monetary Fund (IMF) and periodically distributed to its membership, most recently in the amount of $650 billion in 2021. This special tool can make a difference, and a bigger difference if it is reformed, but to think that it alone can solve the problem is dangerously mistaken.

The climate funding gap will be front of mind when the 28th annual United Nations Climate Change Conference of Parties (COP28) opens in Dubai on November 30. Indeed, the financing challenge is immense. The International Energy Agency estimates that emerging-market and developing economies will not meet Paris Agreement commitments unless their clean energy investments rise from $770 billion per year in 2022 to $2.2 trillion to $2.8 trillion per year over the next decade. Leaving China aside, the clean energy commitments of this group would need to rise from $260 billion per year to $1.4 trillion to $1.9 trillion annually to meet Paris Agreement goals. These sums, however daunting, do not include the costs of urgent investments in adapting to-not just mitigating-the threat of global warming.

The SDR's potential contribution to financing climate mitigation and adaptation should not be exaggerated. According to advocates, the IMF magically creates money when it allocates SDRs, money that poorer countries could use to decarbonize their economies and build resilience against climate change. Alas, this claim overstates the positive role that SDRs can play. The claim is not just wrong, it is harmful: It may crowd out serious discussion of additional necessary measures, while supplying talking points to politically influential rich-country critics who oppose further issuance of SDRs.

To see why, it is necessary to understand the unique characteristics of the SDR.[1]

The mechanics of the SDR

In an SDR allocation, each IMF member receives interest-bearing reserve assets and corresponding long-term liabilities on which it pays interest at the same rate. The SDR's value is based on a basket of five "freely usable" currencies with weights set periodically by the IMF.[2] The interest rate on an SDR depends on the short-term interest rates of the constituent currencies. SDR allocations are not cash distributions or even loans. An SDR allocation is costless, and it imposes no costs on any IMF member until the SDRs are used.

Even before the SDRs are used, they confer benefits on countries that might otherwise have to distort their economic policies to accumulate precautionary balances of reserve assets. Their benefits are even greater, however, for countries that need to use them. Lower-income countries that are short on international liquidity can exchange their SDRs with other SDR holders for freely usable currencies. The direct fiscal cost to the SDR buyer, if any, depends on a comparison of the yield they earn on the SDRs with what they would have earned on the reserve currencies they part with.[3] The benefit to the SDR seller is likely to be much higher, however, since to obtain usable currency, it pays the SDR interest rate rather than the much higher borrowing rate it would likely face in the international capital market-if it can borrow at all.

What explains this apparent free lunch? It is the credibility of the commitment that all IMF members have made to accept SDRs and not to default on their SDR liabilities to the IMF. For many IMF members, large-scale SDR issuance would undermine this credibility, limiting support for allocations big enough to reduce substantially the climate funding gap.

Rechanneling SDRs

SDR allocations are not currently targeted to countries most in need. They are distributed proportionally to IMF quotas, meaning that rich countries, which do not need them, get the bulk of every SDR allocation. Even though the small share of any SDR allocation that goes to low- and middle-income countries limits the extent to which they can use their own SDRs to finance climate mitigation and adaptation, a more promising avenue to leverage the benefits of SDR allocations is for rich countries to lend SDRs to "prescribed holders." These authorized entities include the IMF itself and the multilateral development banks (MDBs). Under current policies, as long as these loans are judged by the IMF to preserve the reserve asset character of the SDR, the prescribed holder can convert the SDR into currencies to lend, or lend the SDR directly, or use the SDR in effect for capital to support market borrowing, which is then channeled to borrowers in the developing world.

Such recycling of SDRs normally entails an interest cost to the authorized borrowing entity. If it wants to make low or reduced interest loans, those loans need to be subsidized by countries lending the SDRs to the entity. For this and other reasons, it has been difficult to generate political support for SDR recycling, despite the comparatively low costs and big potential impacts. The IMF's new Resilience and Sustainability Trust (RST), which began operating in 2022, works on this model, borrowing SDRs from rich countries and lending them at low interest rates to support climate- and health-related investments. As of September 15, 2023, the RST had secured pledges of $41.1 billion but made only a limited number of loans.[4]

In an important development, the African Development Bank and the Inter-American Development Bank have proposed a new platform for rechanneling richer countries' SDRs into capital that MDBs could leverage for development and climate-resilience loans. This proposal will be further elaborated at COP28, and IMF staff have reportedly signaled that SDR loans made via the proposed instrument would be considered to retain reserve-asset status. SDR loans channeled through MDBs are a very promising mechanism for magnifying the benefits of SDR allocations for poorer countries.

SDRscan help more but are not enough

Several measures could enhance the beneficial role of SDRs.

• Regular annual allocations would ensure a steady growth in global liquidity, as envisaged when the SDR was created. As noted above, more recycling of SDRs through the MDBs would scale up their impact, and at the same time help to mobilize private capital to fund the green transition.
• The IMF is overly protective of the reserve asset characteristic of the SDR in requiring a judgment that any recipient entity maintain the liquidity of the SDRs, sometimes by setting aside a portion of the amount transferred in the unlikely event they need to be used for balance of payments purposes. Thus, the SDRs are incompletely mobilized. The IMF should sharply modify its policies in this area. Even if SDRs transferred to an entity are immobilized for a period to address the need for a global public good, they do not disappear from the system.
• It makes sense to tie the SDR interest rate to some extent to the long-term rates of the constituent currencies. When the term structure of interest rates is upward-sloping, as in normal times, this would reduce the net fiscal cost for countries that acquire SDRs from other countries, perhaps reducing some of the political opposition to SDR allocations. When the term structure is downward-sloping, as when a recession is expected, the interest burden of SDRs for countries that mobilize their holdings would be lower than under the current convention.

As helpful as all these changes would be, they are not sufficient in scale to make a decisive contribution to meeting the global challenges of climate mitigation and adaptation. Recycled SDRs are bilateral loans, but addressing the climate crisis adequately requires a much bigger scale of loans than can be supported by SDRs, as well as substantial outright grants to less prosperous nations. Unfortunately, even rich countries' past promises to recycle SDRs have not been fulfilled. Current proposals to leverage the World Bank's capital more effectively will help as well, but doing so would be no substitute for a capital increase. IMF members have agreed to a 50 percent proportional increase in quotas, which will strengthen the global financial safety net, and that step would complement future SDR issuance. To address adequately and expeditiously the climate crisis, however, governments and legislatures of the advanced economies must directly fund comprehensive, global efforts.

Neither the cheerleaders for using SDRs to address the climate crisis nor the SDR critics have it right. SDRs cost nothing to issue and involve only minor fiscal costs for high-income countries. But the benefits to poorer countries, which must pay high interest rates to borrow abroad (if they can borrow at all), are much larger, especially when compared with those countries' incomes. The international community can and should take steps to leverage the SDR's positive impact. However, high-income countries will need to do much more to make good on their past promises and adequately support low- and middle-income countries in coping with the climate crisis.

The authors thank Madona Devasahayam, Adnan Mazarei, and Steve Weisman for their help and comments.

Notes

1. In an earlier paper, one of us (Truman) explains technical details and the history of the SDR.

2. The basket currencies are those of the United States (dollar), the euro area (euro), China (renminbi), Japan (yen), and the United Kingdom (sterling).

3. For example, the SDR interest rate for the week of November 13-19, 2023, was 4.175 percent per year. The US 3-month Treasury rate used to compute the SDR interest rate was 5.42 percent per year that week..

4. SDRs are also rechanneled to low-income countries through the IMF's Poverty Reduction and Growth Trust, set up in 1999.

This publication does not include a replication package.