By Lesley Wroughton
WASHINGTON, Nov 11 (Reuters) - The International Monetary Fund is expected to consider by the end of the month possible changes to the basket of currencies that make up the IMF Special Drawing Right, which has been mentioned as a potential future global reserve currency.
The basket was created by the IMF over 40 years ago to serve as an international reserve asset. Its value is based on a basket of "freely usable" currencies -- the dollar, the euro, the British pound and Japanese yen. A review of the basket is usually conducted every five years.
Discontent with a weakening U.S. dollar has sparked interest in finding alternatives to supplant the greenback's dominant role in the global economy, putting a fresh focus on SDRs.
Below are some questions and answers about SDRs and the SDR basket.
WHAT IS THE SDR?
The SDR was created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system. Countries participating in this system needed official reserves -- gold and the U.S. dollar -- that could be used when needed to purchase their local currency in foreign exchange markets, as required to maintain its exchange rate.
But the international supply of the two reserve assets was not enough to support growing world trade and financial developments. The international community decided to create the SDR as a new international reserve asset under the auspices of the IMF.
It is not a currency. It can be held and used by member countries, the IMF and certain designated official entities called "prescribed holders." SDRs can be traded for one of the "freely usable" currencies through voluntary trading arrangements among official SDR holders, and there is also a backstop system to ensure the liquidity of the SDR for countries with balance of payments needs.
These official SDRs cannot be held, for example, by private entities or individuals, but the private sector can denominate bonds and deposits in SDRs. They serve as the unit of account of the IMF and other global institutions, like the Bank for International Settlement.
WHY IS THE UPCOMING SDR REVIEW OF INTEREST?
The meteoric rise of emerging market economies such as China, India and Brazil has prompted increased debate over whether the world needs a reformed monetary system, in which currencies such as the Chinese yuan play a more prominent role.
China is now the world's second-largest economy, although its currency is not convertible on the capital account and therefore it is barely used outside China.
In March 2009, Chinese central bank governor Zhou Xiaochuan suggested the dollar could give way as the premier reserve currency to a beefed-up SDR.
Russia too has called for the expansion of the SDR to include its currency, the ruble, plus the yuan and gold.
More recently, Brazil's Central Bank President Henrique Meirelles on Thursday said he favored replacing the U.S. dollar as the world's reserve currency with the SDR. [nN11285253]
France, which takes over the rotating chair of the Group of 20 major economies next week, wants to make global monetary reforms the focus of its presidency. A thorny issue, according to French officials, is the diversification away from the dominance of the dollar.
The upcoming SDR review would be an opportunity to expand or alter the composition of currencies that make up the SDR basket.
WHO DECIDES ON THE COMPOSITION OF THE SDR BASKET?
The decision is in the hands of the IMF executive board, which represents member countries. Any SDR decision needs the support of 70 percent of the voting power in the 24-member board.
Under some principles that have guided past IMF reviews, the composition of the SDR should be representative of the currencies used internationally. It also should be stable, so it it should not include too much of any one currency.
In its review five years ago, the IMF concluded that the SDR should be weighted at 44 percent U.S. dollar, 34 percent euro, 11 percent yen and 11 percent pound. At the time, the countries behind these currencies represented more than 50 percent of world exports.
The deadline for a decision in the review is January 1; however, the board could simply decide to defer its decision. If the board meets later this month, as expected, it could emerge with an immediate decision, as in past 5-yearly reviews, or agree to a postponement.
WHAT DOES THE IMF MEAN BY A 'FREELY USABLE' CURRENCY?
The IMF's use of the phrase 'freely usable' currencies as part of the SDR basket refers to those that are widely used in international transactions and those that are widely traded on foreign exchange markets.
It does not mean freely floating. Nor does it mean freely convertible, although in practice convertibility facilitates international transactions and trading in foreign exchange markets. It also has nothing to do with capital controls or an exchange rate regime of a specific country.
According to analysts, the yuan falls short of the "freely usable" criterion. Some have suggested that the inclusion of the Canadian dollar or the Korean won in the SDR would be a good addition to the big four reserve currencies.
WHAT HAPPENS IN THE SDR REVIEW PROCESS?
At the time of a review, IMF staff present a report to the executive board, providing analysis and options for possible changes to the SDR, including proposals for re-weighting each currency within the basket.
Among issues considered in the review are exports of countries and composition of international reserves. Also, various indicators about the use of currencies such as international bank liabilities, foreign exchange turnover and global debt securities are also taken into account.
HOW OFTEN IS THE SDR BASKET ALTERED?
There have been relatively few changes in the SDR basket since it was established. The basket was originally made up of 16 currencies. It was streamlined to five in 1980 to make it more of a reserve asset, as the five currencies (dollar, yen, pound, Deutsche mark and French franc) had deep foreign exchange markets. The next change was in 2000 when the euro replaced the Deutsche mark and French franc.
An overhaul in the make-up of the SDR basket could be forced by a decision by major economies to reform the international financial system, as was the case with the introduction of the euro in 1999.
Some additional IMF principles, which aim to ensure a measure of predictability in the make-up of the SDR, stipulate that the composition of the basket should only change as a result of "significant developments" from previous reviews. They also say that any revisions of the criteria for selecting the currencies in the SDR, and their weights in the basket, should occur only when there are major changes in the roles of currencies in the world economy.
WHAT IS THE NEXT STEP?
The IMF board meets at the end of November to decide whether or not to change the composition of the SDR basket. It is hard to predict what the likely outcome will be until there is more clarity from politicians.
If the IMF were to include the yuan, it would be an acknowledgment of China's rising clout.
Including the yuan in the SDR basket seems an obvious first step and is something the Chinese are ready to discuss, a French official told Reuters.
A more-representative SDR would appeal to asset managers and, in theory, could slowly transform it into a real currency. For now, however, the dollar looks set to remain the dominant reserve currency for some time to come. (Editing by Dan Grebler)