Can SDRs Be Used for Loss and Damage Finance?

At COP27 last November, the parties agreed to provide “loss and damage” funding for vulnerable countries hit hard by climate disasters. Governments also agreed to establish a “transitional committee” to make recommendations on how to operationalize both the new funding arrangements and the fund at COP28 next year. A key question will be, Where will the money come from?

Some have proposed using the pool of almost $1 trillion of Special Drawing Rights (SDRs) held by countries worldwide. SDRs are attractive because, at first blush, they seem to provide a budget-free source of funding that could be in the trillions of dollars. But a close look at the nature of SDRs and the inherent constraints on their use show that at the very best they could be small part of a portfolio of financing for loss and damage (L&D) financing. And they can only be used effectively for loans, whereas many view grants as the appropriate form of L&D financing. SDRs cannot be used to get around the fact that L&D financing will be costly to provide. 

What are SDRs, and how do they work?

An SDR is a reserve asset allocated by the IMF to its member countries. There are now SDR 660.7 billion in the world, with a total value of US$876 billion. The value of the SDR fluctuates daily. The allocation is proportionate to each country's IMF quota or membership share. SDRs are the property of each country, not the IMF, which provides administrative functions.

Fifteen other institutions, like the World Bank, the African Development Bank, and the Latin-American Reserve Foundation (FLAR), are allowed to hold SDRs as an asset, but they do not receive any allocation directly from the IMF.

Each country has its own internal rules about how to use its SDRs. Most countries hold SDRs as part of their international reserves, much like dollars, yen, or euros. Governments can use SDRs to make international payments to other SDRs holders; for example, to pay debt service to the IMF or World Bank. Countries can support each other financially with SDRs. For example, a few countries have transferred SDRs to Ukraine to boost Ukraine's international reserves during the war.

SDRs are not money. SDR holders cannot use them to purchase anything. But should a country lack foreign exchange to import needed goods (vaccines, for example), it can exchange SDRs for hard currency.

Advanced countries hold large balances of SDRs, which they do not actively use. While these SDRs provide an added cushion against global economic shocks (like that occurring from COVID), large countries have many other ways of adjusting.

Countries not needing their entire SDR endowment have "recycled" these SDRs to help more vulnerable countries. Many advanced economy countries have lent some of their SDRs to special funds at the IMF, which the IMF then onlends to low- and middle-income countries facing balance of payments problems. These loans give the countries added room to adjust to global shocks. The African Development Bank has also proposed using advanced-economy countries' SDRs as hybrid capital. It would then leverage this capital into loanable funds at 2-4 times the amount of SDRs in the capital pool. But the scale of this lending is small—no more than $100 billion.

Countries pay and receive interest on SDR holdings. The IMF keeps track of how many SDRs it has allocated to each country. Countries whose holdings are greater than their allocation earn interest, and those whose holdings are less than their allocation pay interest. For example, if France were to give SDR20 million permanently to Côte d'Ivoire, France would have to pay SDR564 thousand per year in interest to the IMF at current interest rates. At the same time, Côte d'Ivoire would receive SDR564 thousand per year in interest.

How might SDRs be used for L&D?

The exact nature of L&D finance has yet to be determined—to whom, for what and by whom. The impact of climate change varies considerably across countries (and within countries) and over time. Calibrating what damages are to be compensated and when will present a considerable challenge for the transitional committee. Substantial resources will also be needed by many developing countries to adapt to the new climate reality and, for some, to mitigate carbon emissions. And this is at a moment when government balances sheets are strained, and many developing countries are facing serious difficulties managing their debt. One task of the transitional committee will be to determine the form in which financing will be given—through grants or loans.

If there are many unused SDRs on advanced countries' balance sheets, could they be used for loss and damage? In a comprehensive paper on options for financial mechanisms for L&D, Michael Franczak considers various possibilities for mobilizing SDRs for L&D. The refrain has been picked up by others as well. But the nature of SDRs limit the way they can be used.

SDRs are a clumsy way to give grants. For some types of L&D, like financial relief after a hurricane, countries will need grants—one-off payments that they do not need to reimburse. But making SDR grants is problematic. Let's take a simple example: If the US were to grant SDRs to Haiti to rebuild roads after a hurricane, the US would incur a perpetual interest cost because it depleted its SDRs. Haiti would get the SDRs, but it couldn't spend them on roads—it would have to exchange them for hard currency—dollars, for example, which it might get from the US. So, by the end of the transaction, the net effect is that the US gave dollars to Haiti—there is no compelling reason to do so through the medium of SDRs. Enlarging this example to a global scale, grants of SDRs boil down to a transfer of hard currency reserves from contributing countries to receiving countries. Doing this directly rather than through SDR exchanges is much more efficient.

SDRs can be used more effectively for loans. Loaning SDRs solves a few of the problems with grants.

• First, the interest cost to the contributing country can be offset by charging interest to the receiving country. In the simple case of a bilateral loan, the government getting the SDR loan will receive interest on those SDRs from the IMF equal to what the contributing country is paying. The loan terms can thus be structured to offset these two payments, and neither the receiving nor the contributing country is worse off.
• Second, loans allow contributing countries to maintain the “reserve asset characteristic" of the SDR. SDRs represent a potential claim on their hard currency reserves, so they want to ensure they are being used prudently. In current SDR recycling, contributing countries have structured their loans to the IMF so that they can redeem lent SDRs on demand without endangering the onlending that the IMF has undertaken. Furthermore, the loans are structured in such a way as to minimize the risk of default, thus keeping SDR investment relatively safe. Maintaining low risk and "encashability” are critical to contributors.
• Finally, loans can leverage the financial power of SDRs. Suppose advanced-economy countries lend SDRs to a multilateral development bank (MDB) as capital. In that case, the MDB can leverage the SDRs on private capital markets, and loanable funds will increase by multiples of the capital, potentially three to four times as much as the SDRs themselves. Recycling SDR10 million through MDB recapitalization might generate SDR40 million in loans to recipient countries. In contrast, with direct recycling between countries, SDR10 million yields SDR10 million, and through the IMF, SDR10 million recycling yields less than SDR10 million in loans. 

But are loans appropriate for L&D purposes? In an era where many are worried about increasing indebtedness, recipient countries should hesitate to take on more debt, particularly if it is for L&D. And there is clearly a case to be made for grants to compensate for wealth lost due to climate change. But there are instances where loans may be an appropriate instrument. For example, SDR-based loans could mitigate a temporary foreign exchange loss from climate change, say from a decline in agriculture exports. They could also help countries make the investment needed to develop new export products or undertake policy changes (such as rationalizing carbon subsidies and taxation) that have short-term economic costs, but longer-term economic and climate benefits. SDR-based loans could also augment the capacity of the IMF and MDBs to help countries when there are sudden climate or pandemic emergencies. The extent to which loans could be a helpful tool will depend on what L&D the UNFCCC task force decides should be compensated and what form of payment recipient countries are willing to accept.

The advantage of SDR-based loans is that they can be done at a low cost to both contributor and recipient and often rapidly. The interest cost of SDRs is well below market rates and, if intermediated through the MDBs, can be provided at very low rates, even accounting for the cost of leverage. And SDR loans can be made concessional for a fraction of the cost of grant finance. The current interest rate on the IMF's Poverty Reduction and Growth Trust is zero, thanks to donors agreeing to absorb the interest cost of the onlent SDRs.

What might the institutional structure look like for SDR L&D loans?

The transitional committee will also have to determine what institutions will deliver the L&D financing. There is a desire to get the money as close to the impacted people as possible, but there will have to be intermediate institutions to collect the money and redistribute it. The nature of SDRs will likely require that they be intermediated by existing institutions, such as the IMF, World Bank, or regional development banks.

SDR lending must be based at an institution that is a prescribed holder of SDRs. Whether SDRs are onlent directly or leveraged, the institution administering the loans will have to be able to hold SDRs in its accounts. Otherwise, donated SDRs will have to be converted to hard currency before they get to the institution, which raises the question of why SDRs are being used.

Current prescribed holders are well established. The IMF has designated 15 institutions as prescribed holders of SDRs and is considering designating a few more. They are all publicly held international financial institutions whose primary clients are sovereign countries, not private entities. Their governing boards are composed of representatives from member countries with established records of good governance and transparency. They are conservatively managed, most enjoying high ratings from the international ratings agencies.

The least complicated way to use SDRs for L&D would be through an existing prescribed holder. While there is merit to the idea of creating a new fund for L&D, it will create a host of challenges, as Franczak indicated in his paper. Adding SDRs into the funding mix for a new institution will be a high hurdle. After all, some long-standing institutions, such as the Inter-American Development Bank, have yet to be named as prescribed holders. And it is doubtful that any freestanding fund will be able to leverage SDRs on the private market, thus severely limiting its effectiveness in using SDRs.

Closing thoughts

Experts will spend the next year figuring out how to structure the financing and delivery of L&D payments. But given the current international financing landscape, particularly the severe budget constraints that advanced-economy countries face, the financing sources will likely be diverse. And no single fund will be able to administer them all. SDRs could be useful for financing some part of L&D but within the narrowly defined set of procedures and institutions.

For some, SDRs seem the magic solution—a budget-free source of funding that could be in the trillions of dollars. But those hopes are quickly dashed once one looks closely at the nature of SDRs and the inherent constraints on their use. They might be able to help, but they can't solve the problem. The global community must face the unpleasant truth that L&D will cost “real money.”