More than a year after the IMF general allocation of Special Drawing Rights (SDRs) and the G20 promise to recycle $100 billion of SDRs, how much has been achieved? The quick answer: $60 billion has been pledged, and there is hope that the United States will contribute another $21 billion. But how will the recycled SDRs be used?
The IMF would like to absorb about $65 billion through the Poverty Reduction and Growth Trust (PRGT) and the Resilience and Sustainability Trust (RST), which leaves about $35 billion looking for a home. As we have noted elsewhere, multilateral development banks (MDBs) seem a logical place to use some SDRs. However, MDBs are still without any SDRs, despite being on the frontlines of the main challenges we face, especially climate finance and achieving the Sustainable Development Goals (SDGs). MDBs have been snubbed by SDR holders looking for recycling options because of the technical hurdles.
The first challenge lies in the mechanics of the SDR system: not everyone can hold SDRs. Only certain institutions and countries are prescribed holders. Some MDBs have this status, and some do not. Also, the G20 has insisted that recycled SDRs maintain their reserve asset characteristic; they must be easily recalled if needed and not put at too much risk. But MDB investments are long term and riskier than, say, government bonds. So using SDRs at the MDBs is not a natural fit.
Some MDBs are considering using a hybrid capital structure to overcome these problems. In this blog, we briefly explain the nature of hybrid capital and how SDRs might come into play.
What is hybrid capital?
The most obvious question regarding hybrid capital is, what makes it hybrid? Suppose you have money to invest. You could purchase equity (that is, company shares), thus making you an owner who will share in the enterprise’s profits. Or you can buy fixed-income securities (that is, bonds), through which you lend your money to the company with the promise of reimbursement plus interest.
Hybrid capital (or synthetic security) is a fixed-income financial instrument with both equity and debt properties. It is sold to investors as a fixed-income instrument (like a bond), and it does not dilute the capital of the MDB. But the terms offered by the instrument make it look like a permanent investment in the institution: it has a perpetual maturity (i.e., the MDB never intends to pay off or redeem the loan). However, the MDB does offer the investor the opportunity to cash in the bond after an extended period, say 10 years. The hybrid capital would rank senior to paid-in capital but junior to other unsecured debt. However, given the MDBs’ AAA-rated financial management, the risk of lost hybrid capital is minimal. Furthermore, some funds invested in the hybrid capital will be held in reserve should a lending country need to retrieve its SDRs prematurely.
From an accounting perspective, hybrid capital will be considered equity on the MDB balance sheet. This allows the MDB to raise money to increase its loanable funds by issuing bonds, which the hybrid capital guarantees. This so-called leveraging of hybrid capital is regulated by shareholders, who decide how much the MDB can borrow from capital markets. Typically, the MDBs can borrow three to four times the equity value on capital markets and thus lend that much more. Credit rating agencies have broadly accepted this use of hybrid capital. Therefore, the MDB’s credit rating would not be at risk from leveraging the hybrid capital.
Where do SDRs fit in?
MDBs that are looking to expand their lending need more capital. But many of their shareholders are facing fiscal constraints. They cannot spend money from their budgets to increase MDB capital.
The 2021 allocation increased countries’ SDR holdings, and in many advanced countries these assets are sitting unused in country coffers. Investing these unused SDRs in MDB hybrid capital has four advantages:
There is no direct cost to the investing country as the SDRs were a gift from the IMF.
The government does not cede control of its SDRs, as it is lending them to the MDBs and can get them back if needed.
The loan is very low risk compared to other investments.
Each SDR invested leverages three to four times as many loanable funds.
Hybrid capital is not a perfect substitute for increasing paid-in capital. But it does give shareholders an immediate and low-cost opportunity to support the expansion of MDB loans.