INTERNATIONAL FINANCIAL MANAGEMENT

SUBMITTED TO MRS. AARTI MBA DEPARTMENT

SUBMITTED BY Kamal Kant Baluni 05920803911

DOLLARIZATION
Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency as a store of value, unit of account, and/or medium of exchange within the domestic economy. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency. There are two common indicators of dollarization. The first one is the share of foreign currency deposits (FCD) in the domestic banking system in the broad money including of FCD. The second measure is the share of all foreign currency deposits held by domestic residents at home and abroad in their total monetary assets. The biggest economies to have officially dollarized as of June 2002 are Panama (since 1904), Ecuador (since 2000), and El Salvador (since 2001). As of August 2005, the United States dollar, the Euro, the New Zealand dollar, the Swiss franc, the Indian rupee, and the Australian dollar were the only currencies used by other countries for official dollarization. In addition, the Armenian dram, Turkish lira, the Israeli shekel, and the Russian ruble are used by internationally unrecognized but de facto independent states.

ORIGIN
After the gold standard was abandoned at the outbreak of World War I and the Bretton Woods Conference following World War II, some countries were desperately seeking exchange rate regimes to promote global economic stability and hence their own prosperity. Countries usually peg their currency to a major convertible currency. "Hard pegs" are extreme exchange rate regimes that demonstrate a stronger commitment to a fixed parity (i.e. currency boards) or relinquish control over their own currency (such as currency unions and dollarization) while "soft pegs" are more flexible and floating exchange rate regimes.[3] When countries choose to use a major convertible currency parallel to or in place of their national currency, this is called the process of dollarization. The collapse of "soft" pegs in Southeast Asia and Latin America in the late 1990s led dollarization to become a serious policy issue.

TYPES
Dollarization can occur in a number of situations. The most popular type of dollarization is unofficial dollarization or de facto dollarization. Unofficial dollarization happens when residents of a country choose to hold a significant share of their financial assets denominated in foreign currency although the foreign currency lacks the legal tender. They hold deposits in the foreign currency because of a bad track record of the local currency, or as a hedge against inflation of the domestic currency. Official dollarization or full dollarization happens when a country adopts a foreign currency as its sole legal tender, and ceases to issue the domestic currency. Another effect of a country adopting a foreign currency as its own is that the country gives up all power to vary its exchange rate. There is a small number of countries adopting a foreign currency as legal tender. For example, Panama underwent a process of full dollarization by adopting the U.S. dollar as legal tender in 1904. This type of dollarization is also known as de jure dollarization. Dollarization can be used semiofficially (or officially bimonetary systems), where the foreign currency is legal tender alongside the domestic currency. In literature, there is a set of related definitions of dollarization such as external liability dollarization, domestic liability dollarization, banking sector's liability dollarization or namely deposit dollarization and credit dollarlization. The external liability dollarization measures total external debt (private and public) denominated in foreign currencies of the economy.[8][9] Deposit dollarization can be measured as the share of dollar deposit in total deposit of the banking system while credit dollarization can be measured as the share of dollar credit in total credit of the banking system.

EFFECTS
On trade and investment
One of the main advantages of adopting of a strong foreign currency as sole legal tender is reducing the transaction costs of trade among countries using the same currency. There are at least two ways to infer this impact from data. The first one is a significantly negative effect of exchange rate volatility on trade in most cases and the second is an association between transaction costs and the need to operate with multiple currencies. Economic integration with the rest of the world becomes easier as a result of lowered transaction costs and more stable prices in dollar terms. Rose (2000) applied the gravity model of trade and provide empirical evidence that countries sharing a common currency engage in significantly increased trade among them and the benefits of dollarization for trade may be large.

Dollarized economies can invoke greater confidence among international investors inducing increased investments and growth. The elimination of the currency crisis risk due to full dollarization will lead to a reduction of country risk premia and then lower interest rates. These effects will result in a higher level of investment. However, it is evident that there is a positive association between dollarization and interest rates in a dual-currency economy.

On monetary and exchange rate policies

Official dollarization helps promote greater fiscal and monetary discipline and thus greater macroeconomic stability and lower inflation rates, lower real exchange rate volatility, and possibly deepen the financial system. Firstly, dollarization helps developing countries; providing a firm commitment to stable monetary and exchange rate policies by forcing a passive monetary. Adopting a strong foreign currency as legal tender will help to "eliminate the inflation-bias problem of discretionary monetary policy". Secondly, official dollarization also imposes stronger financial constraint on the government by eliminating financing of the deficit by issuing money. An empirical finding suggests that inflation has been significantly lower in dollarized nations than in non-dollarized ones. The expected benefit of dollarization is the elimination of risk of exchange rate fluctuations and possible reduction in the country's international exposure. Though dollarization cannot eliminate the risk of an external crisis, it provides steadier markets as a result of elimination of fluctuations in exchange rates. On the other hand, dollarization leads to the loss of seigniorage revenue, the loss of monetary policy autonomy, and the loss of the exchange rate instruments. Seigniorage revenue are the profits generated when the monetary authorities issue its currency. When adopting a foreign currency as legal tender, the monetary authorities need to withdraw its domestic currency and give up future seigniorage revenue. The country loses the rights to its autonomous monetary and exchange rate policies even in times of financial emergencies; former chairman of the Federal Reserve Alan Greenspan, for example, has stated that the central bank only considers the effects of its decisions to the United States economy. In a full dollarized economy, exchange rates are indeterminate and the monetary authorities can not devalue. In a highly dollarized economy, devaluation policy is less effective in achieving changes in the real exchange rate because of having a high degree of pass-through effects to domestic prices. However, the cost from losing an independent monetary policy exists when the domestic monetary authorities can commit an effective countercyclical monetary policy stabilizing the business cycle. This cost depends adversely on the correlation between business cycle of the client country (dollarized economy) and business cycle of the anchor country. In addition, the monetary authorities in dollarized economies diminish the liquidity assurance to its banking system.

On banking systems
In a fully dollarized economy, the monetary authorities can no longer act as lender of last resort to commercial banks by the printing of money. The alternatives to lending to the bank system might include the use of taxation and the issuance of government debt. The loss of lender of last resort is considered as one cost of full dollarization. This cost depends on the initial level of unofficial dollarization before moving toward a full dollarized economy. This relation is negative because in a heavily dollarized economy, its central bank already fears difficulties to provide liquidity assurance to its banking system. However, the literature points out the existence of alternative mechanisms to provide liquidity insurance to banks such as a scheme by which the international financial community charges an insurance fee in exchange for a commitment to lend to a domestic bank. Commercial banks in countries where saving accounts and loans in foreign currency are allowed may face two types of risks: Currency Mismatch Risk: Assets and liabilities on the balance sheets may be in different denomination. This may arise if the bank converts foreign currency deposits into local currency and lends in local currency or vice versa. Default risk: Arises if the bank uses the foreign currency deposits to lend in foreign currency. However, dollarization eliminates the probability of a currency crisis that impacts negatively on the banking system through the balance sheet channel. Dollarization may reduce the possibility of systematic liquidity shortages and the optimal reserves in the banking system.

DETERMINANTS OF DOLLARISATION PROCESS

The dynamics of the flight from domestic money
High and unanticipated inflation rates decrease the demand for domestic money and raise the demand for alternative assets including foreign currency and assets dominated by foreign currency. This phenomenon is called the "flight from domestic money". The flight from domestic money results in a rapid and sizable process of dollarization. In high inflation countries, the domestic currency tends to be gradually displaced by a stable currency such as the U.S. dollar. At the beginning of this process, the store-of-value function of domestic currency will be replaced by the foreign currency. Then, the unit-of-account function of domestic currency will be displaced when many prices are quoted in a foreign currency. A prolonged period of high inflation will induce the domestic currency to lose its function as medium of exchange when the public carries out many transactions in foreign currency.

THE IMF AT A GLANCE

August 22, 2012

The International Monetary Fund (IMF) works to foster international monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world. Created in 1945, the IMF is governed by and accountable to the 188 countries that make up its near-global membership.

Why the IMF was created and how it works

The IMF, also known as the Fund, was conceived at a United Nations conference convened in Bretton Woods, New Hampshire, United States, in July 1944. The 44 governments represented at that conference sought to build a framework for economic cooperation that would avoid a repetition of the vicious circle of competitive devaluations that had contributed to the Great Depression of the 1930s.

The IMFs responsibilities: The IMF's primary purpose is to ensure the stability of the
international monetary systemthe system of exchange rates and international payments that enables countries (and their citizens) to transact with one other. This system is essential for promoting sustainable economic growth, increasing living standards, and reducing poverty. The Funds mandate has recently been clarified and updated to cover the full range of macroeconomic and financial sector issues that bear on global stability.

Fast Facts on the IMF

Membership: 188 countries Headquarters: Washington, D.C. Executive Board: 24 Directors representing countries or groups of countries Staff: Approximately 2,475 from 156 countries Total quotas: US$360 billion (as of 8/9/12) Additional pledged or committed resources: US$1 trillion

Loans committed (as of 8/9/12): US$243 billion, of which US$186 billion have not been drawn (see table) Biggest borrowers (amount agreed as of 8/9/12): Greece, Portugal, Ireland Biggest precautionary loans (amount agreed as of 8/9/12): Mexico, Poland, Colombia Surveillance consultations: Consultations concluded for 128 countries in FY2011 and for 117 countries in FY2012 Technical assistance: Field delivery in FY2011198.2 person years Transparency: In 2011, about 90 percent of Article IV and program-related staff reports and policy papers were published

Original aims: Article I of the Articles of Agreement sets out the IMFs main goals:
1. 2. 3. 4. 5. promoting international monetary cooperation; facilitating the expansion and balanced growth of international trade; promoting exchange stability; assisting in the establishment of a multilateral system of payments; and making resources available (with adequate safeguards) to members experiencing balance of payments difficulties

Surveillance: To maintain stability and prevent crises in the international monetary system,
the IMF reviews country policies, as well as national, regional, and global economic and financial developments through a formal system known as surveillance. Under the surveillance framework, the IMF provides advice to its 188 member countries, encouraging policies that foster economic stability, reduce vulnerability to economic and financial crises, and raise living standards. It provides regular assessment of global prospects in its World Economic Outlook, financial markets in its Global Financial Stability Report, and public finance developments in its Fiscal Monitor, and publishes a series of regional economic outlooks. The Funds Executive Board has been considering a range of options to enhance multilateral, financial, and bilateral surveillance, including to better integrate the three; improve our understanding of spillovers and the assessment of emerging and potential risks; and strengthen the traction of IMF policy advice. The key findings and policy advice from the various multilateral products are pulled together in Consolidated Multilateral Surveillance Reports. The Executive Board of the IMF recently adopted a new Decision on Bilateral and Multilateral Surveillance, also known as the Integrated Surveillance Decision. The decision provides guidance to the Fund and member countries on their roles and responsibilities in surveillance and will take effect on January 18, 2013. More broadly, in response to the Triennial Surveillance Review completed in October 2011..

Financial assistance: IMF financing provides member countries the breathing room they
need to correct balance of payments problems. A policy program supported by IMF financing is designed by the national authorities in close cooperation with the IMF, and continued financial support is conditioned on effective implementation of this program. In an early response to the recent global economic crisis, the IMF strengthened its lending capacity and approved a major overhaul of the mechanisms for providing financial support in April 2009, with further reforms adopted in August 2010 and December 2011. In the most recent reforms, IMF lending instruments were improved further to provide flexible crisis prevention tools to a broad range of members with sound fundamentals, policies, and institutional policy frameworks. In low-income countries, the IMF doubled loan access limits and is boosting its lending to the worlds poorer countries, with interest rates set at zero through end-2012. SDRs: The IMF issues an international reserve asset known as Special Drawing Rights (SDRs) that can supplement the official reserves of member countries. Two allocations in August and September 2009 increased the outstanding stock of SDRs almost ten-fold to total about SDR 204 billion (US$312 billion). Members can also voluntarily exchange SDRs for currencies among themselves. In a recent paper, IMF staff explore options to enhance the role of the SDR to promote stability of the international monetary system.

Technical assistance: The IMF provides technical assistance and training to help member
countries strengthen their capacity to design and implement effective policies. Technical assistance is offered in several areas, including tax policy and administration, expenditure management, monetary and exchange rate policies, banking and financial system supervision and regulation, legislative frameworks, and statistics.

Resources: The IMFs resources are provided by its member countries, primarily through
payment of quotas, which broadly reflect each countrys economic size. At the April 2009 G-20 Summit, world leaders pledged to support a tripling of the IMF's lending resources from about US$250 billion to US$750 billion. To deliver on this pledge, the then current and new participants in the New Arrangements to Borrow (NAB) agreed to expand the NAB to about US$570 billion, which became effective on March 11, 2011 following completion of the ratification process by NAB participants. When concluding the 14th General Review of Quotas in December 2010, Governors agreed to double the IMFs quota resources to approximately US$730 billion and a major realignment of quota shares among members. When the quota increase becomes effective, there will be a corresponding rollback in NAB resources. In mid2012, member countries announced additional pledges to increase the IMFs resources to $456 billion to help strengthen global economic and financial stability.

Governance and organization: The IMF is accountable to the governments of its member
countries. At the top of its organizational structure is the Board of Governors, which consists of one Governor and one Alternate Governor from each member country. The Board of Governors meets once each year at the IMF-World Bank Annual Meetings. Twenty-four of the Governors sit on the International Monetary and Financial Committee (IMFC) and normally meet twice each year. The day-to-day work of the IMF is overseen by its 24-member Executive Board, which represents the entire membership; this work is guided by the IMFC and supported by the IMF staff. In a package of reforms approved by the Governors in December 2010, the Articles of Agreement will be amended so as to facilitate a move to a more representative, all-elected Executive Board. The Managing Director is the head of the IMF staff and Chairman of the Executive Board, and is assisted by four Deputy Managing Directors.

India's Quota and Ranking:

India's current quota in the IMF is SDR (Special Drawing Rights) 5821.50 million, giving it a shareholding of 2.44 %. Based on voting share, India (together with its constituency countries viz. Bangladesh, Bhutan and Sri Lanka) is ranked 17th in the list of 24 constituencies. The IMF reviews members' quotas once in five years and the last such review took place in December, 2010. India has already consented to its quota increase under the 2010 review and after the 2010 quota review comes into effect, our quota share will increase from the current 2.44% to 2.75%, making India the eight largest quota holding country at the IMF up from its previous position of being the 11th largest. In absolute terms, India's quota will increase to SDR 13,114.4 million from SDR 5,821.5 million (an increase of approximately US$ 11.5 billion or INR 56,000 crore). While 25% of quota increase (about INR 14,000 crore) is to be paid in cash (reserve currency), the balance 75% can be paid in securities. These securities are non-interest bearing note purchase agreements issued by RBI and can be encashed at any time required by the IMF. They do not entail any cash outgo unless the IMF calls upon India to encash a portion of these notes. The reserve asset portion of Quotas is counted as a part of country's Reserves.

Borrowings by India:
India borrowed SDR 3.9 billion during the period 1981-84. Again during 1991 to 1993, India borrowed an amount of SDR 3.56 billion (SDR 1351.98 million under the Compensatory and Contingency Financing Facility and SDR 2207.925 million under Standby Arrangement). Repayment of all the loans taken from International Monetary Fund has been completed on May 31, 2000. India is now a contributor to the IMF.

SPECIAL DRAWING RIGHTS

Special drawing rights (SDRs) are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund (IMF). Not a currency, SDRs instead represent a claim to currency held by IMF member countries for which they may be exchanged. As they can only be exchanged for euros, Japanese yen, pounds sterling, or US dollars, SDRs may actually represent a potential claim on IMF member countries' non gold foreign exchange reserve assets, which are usually held in those currencies. While they may appear to have a far more important part to play, or, perhaps, an important future role, being the unit of account for the IMF has long been the main function of the SDR. Created in 1969 to supplement a shortfall of preferred foreign exchange reserve assets, namely gold and the US dollar, the value of a SDR is defined by a weighted currency basket of four major currencies: the US dollar, the euro, the British pound, and the Japanese yen. SDRs are denoted with the ISO 4217 currency code XDR. SDRs are allocated to countries by the IMF. Private parties do not hold or use them. As of March 2011, the amount of SDRs in existence is around XDR 238.3 billion, but this figure is expected to rise to XDR 476.8 billion by 2013.

Name
The SDR was purposefully given an innocuous name free of connotations due to controversy, as disagreements broke out over the nature of this new reserve asset during its creation. Some wanted it to function like money and others, credit. While the name would offend neither side of this debate, it can be argued that prior to 1981 the SDR was a debt security and so a form of credit. Member countries receiving SDR allocations were required by the reconstitution provision of the SDR articles to hold a prescribed number of SDRs. If a state used any of its allotment, it was expected to rebuild its SDR holdings. As the reconstitution provisions were abrogated in 1981, the SDR now functions less like credit than previously. Countries are still expected to maintain their SDR holdings at a certain level, but penalties for holding fewer than the allocated amount are now less onerous. The name may actually derive from an early proposal for IMF "reserve drawing rights". The word "reserve" was later replaced with "special" because the idea that the IMF was creating a foreign exchange reserve asset was contentious.

History
Special drawing rights were created by the IMF in 1969 and were intended to be an asset held in foreign exchange reserves under the Bretton Woods system of fixed exchange rates. After the collapse of that system in the early 1970s the SDR has taken on a far less important role. Acting as the unit of account for the IMF has been its primary purpose since 1972. The IMF itself calls the current role of the SDR "insignificant". Developed countries, who hold the greatest number of SDRs, are unlikely to use them for any purpose. The only actual users of SDRs may be those developing countries that see them as "a rather cheap line of credit". One reason SDRs may not see much use as foreign exchange reserve assets is that they must be exchanged into a currency before use. This is due in part to the fact private parties do not hold SDRs: they are only used and held by IMF member countries, the IMF itself, and a select few organizations licensed to do so by the IMF. Basic functions of foreign exchange reserves, such as market intervention and liquidity provision, as well as some less prosaic ones, such as maintaining export competitiveness via favorable exchange rates, cannot be accomplished directly using SDRs. This fact has led the IMF to label the SDR as an "imperfect reserve asset". Another reason they may see little use is that the number of SDRs in existence is relatively few. As of January 2011, SDRs represented less than 4% of global foreign exchange reserve assets.[imf 4] To function well a foreign exchange reserve asset must have sufficient liquidity, but SDRs, due to their small number, may be perceived to be an illiquid asset. The IMF says, "expanding the volume of official SDRs is a prerequisite for them to play a more meaningful role as a substitute reserve asset".

Alternative to US dollar
The SDR comes to prominence when the US dollar is weak or otherwise unsuitable to be a foreign exchange reserve asset. This usually manifests itself as an allocation of SDRs to IMF member countries. Distrust of the US dollar is not the only stated reason allocations have been made, however. One of its first roles was to alleviate an expected shortfall of US dollars c. 1970. At this time, the US had a conservative monetary policy and did not want to increase the total amount of US dollars in existence.[ If the US had continued down this path, the dollar would have become a less attractive foreign exchange reserve asset: it would not have had the necessary liquidity to serve this function. Soon after SDR allocations began, the US reversed its former policy and provided sufficient liquidity. In the process a potential role for the SDR was removed. During this first round of allocations, 9.3 billion SDRs were distributed to IMF member countries.

The SDR resurfaced in 1978 when many countries were wary of taking on more foreign exchange reserve assets denominated in US dollars. This suspicion of the dollar precipitated an allocation of 12 billion SDRs over a period of four years. Concomitant with the financial crisis of 20072010, the third round of SDR allocations occurred in the years 2009 and 2011. The IMF recognized the financial crisis as the cause for distributing the large majority of these third-round allotments, but some allocations were couched as distributing SDRs to countries that had never received any and others as a re-balancing of IMF quotas, which determine how many SDRs a country is alloted, to better represent the economic strength of emerging markets.[8] In total, 203.4 billion SDRs were allocated in this round. During this time China, a country with large holdings of US dollar foreign exchange reserves, voiced its displeasure at the current international monetary system promoting measures that would allow the SDR to "fully satisfy the member countries' demand for a reserve currency". These comments, made by a chairman of the People's Bank of China, Zhou Xiaochuan, drew media attention, and the IMF showed some support for China's stance. It produced a paper exploring ways the substance and function of the SDR could be increased. China has also suggested the creation of a substitution account to allow exchange of US dollars into SDRs. When substitution was proposed before, in 1978, the US appeared reluctant to allow such a mechanism to become operational. It is likely just as reluctant today.

Use by developing countries

In 2001, the UN suggested allocating SDRs to developing countries for use by them as cost-free alternatives to building foreign exchange reserves though borrowing or running current account surpluses.[12] In 2009, a SDR allocation was made to countries that had joined the IMF after the 19791981 round of allocations was complete (and so had never been allocated any). First proposed in 1997, many of the beneficiaries of this 2009 allocation were developing countries.

Value definition
The value of the SDR is determined by the value of several currencies important to the worlds trading and financial systems. Initially its value was fixed, so that 1 SDR = 1 US dollar, but this was abandoned in favor of a currency basket after the 1973 collapse of the Bretton Woods system of fixed exchange rates. Composed of the US dollar, the euro, the British pound and the Japanese yen,[1] the basket of currencies used to value the SDR is "weighted" meaning that the more important currencies have a larger impact on its value. Currently, the value of one SDR is equal to the sum of 0.423 euros, 12.1 yen, 0.111 pounds, and 0.66 US Dollars.

Current valuation Due to fluctuating exchange rates, the relative value of each currency varies continuously and so does the value of the SDR. The IMF fixes the value of one SDR in terms of US dollars daily. The latest US dollar valuation of the SDR is published on the IMF web site.

Value of 1 SDR (XDR 1) Period 19811985[49] US$ 0.540 (42%) 0.452 (42%) 0.572 (40%) 0.582 (39%) US$ DEM 0.460 (19%) 0.527 (19%) 0.453 (21%) 0.446 (21%) EUR 0.2280 (21%) 0.1239 (11%) FRF 0.740 (13%) 1.020 (12%) 0.800 (11%) 0.813 (11%) JPY 34.0 (13%) 33.4 (15%) 31.8 (17%) 27.2 (18%) JPY GBP 0.0710 (13%) 0.0893 (12%) 0.0812 (11%) 0.1050 (11%) GBP

19861990[49]

19911995[49]

19961998[49] Period

19992000[49]

0.5820 (39%)

27.2 (18%)

0.1050 (11%)

= 0.3519 (32%)[50] 20012005[49] 0.5770 (44%) 0.6320 (44%) 0.4260 (31%) 21.0 (14%) 18.4 (11%) 12.1000 (9.4%) 0.0984 (11%) 0.0903 (11%) 0.1110 (11.3%)

20062010[49]

0.4100 (34%)

0.6600 2011 [47][note 2] (41.9%) 2015

0.4230 (37.4%)

Interest rate
Special drawing rights carry a weekly determined interest rate, but no party pays interest if an IMF member country maintains the amount of SDRs allocated to it. Based on "a weighted average of representative interest rates on short-term debt in the money markets of the SDR basket currencies", interest is paid by an IMF member country if it holds less SDRs than it was allocated, and interest is paid to a member country if it holds more SDRs than the amount it was allocated.[1]

Allocations
Special drawing rights are allocated to member countries by the IMF. A country's IMF quota, the maximum amount of financial resources that it is obligated to contribute to the fund, determines its allotment of SDRs. Any new allocations must be voted on in the SDR Department of the IMF and pass with an 85% majority. All IMF member countries are represented in the SDR Department, but this is not a one country, one vote system.[ Voting power is determined by a member country's IMF quota.[51] For example, the US has 16.7% of the vote as of March 2, 2011. Allocations are not made on a regular basis and have only occurred on several occasions. The first round took place due to a situation that was soon reversed, the possibility of an insufficient amount of US dollars because of US reluctance to run the deficit necessary to supply future demand. Extraordinary circumstances have, likewise, led to the other SDR allocation events. Date 19701972 19791981 August 28, 2009 September 9, 2009 Sometime after March 3, 2011 Amount XDR 9.3 billion XDR 12.1 billion XDR 161.2 billion XDR 21.4 billion XDR 20.8 billion

^ A special allocation of SDRs became effective August 10, 2009 and was issued on September 9, 2009, to countries that joined the IMF after 1981 and so had never been allocated any.[1] ^ This allocation was made under the 2008 Quota and Voice Reforms to 54 countries with "dynamic economies" that were under-represented in the previous quota system.

Exchange
In order to use its SDRs, a country must find a willing party to buy them. The IMF acts as an intermediary in this voluntary exchange; it also has the authority under the designation mechanism to ask member countries with strong foreign exchange reserves to purchase SDRs from those with weak reserves The maximum obligation any country has under this mechanism is currency equal to twice the amount of its SDR allocation. As of 2011, SDRs may only be exchanged for euros, Japanese yen, UK pounds, or US dollars. The IMF says exchanging SDRs can take "several days". It is not, however, the IMF that pays out foreign currency in exchange for SDRs: the claim to currency that SDRs represent is not a claim on the IMF.

Other uses
The SDR is used as a unit of account by some international organizations, including the IMF; a few countries peg their currencies to SDRs. In addition, charges, liabilities, and fees prescribed by some international treaties are denominated in SDRs.

Unit of account
Some international organizations use the SDR as a unit of account. The IMF says using the SDR in this way "help[s] cope with exchange rate volatility". As of 2001, organizations that use the SDR as a unit of account, besides the IMF itself, include: African Development Bank, Arab Monetary Fund, Asian Development Bank, Bank for International Settlements, Common Fund for Commodities, East African Development Bank, Economic Community of West African States, International Center for Settlement of Investment Disputes, International Fund for Agricultural Development, and Islamic Development Bank. It is not only international organizations that use the SDR in this way. JETRO uses SDRs to price foreign aid and the Reserve Bank of New Zealand, foreign reserves.

Use in international law

In some international treaties and agreements, SDRs are used to value penalties, charges or prices. For example, the Convention on Limitation of Liability for Maritime Claims caps personal liability for damages to ships at XDR 330,000.[56] The Montreal Convention and other treaties also use SDRs in this way.

Currency peg
The IMF says, "the SDR may not be any countrys optimal basket", but a few countries do peg their currencies to the SDR. One possible benefit to nations with SDR pegs is that they may be perceived to be more transparent. As of 2000, the number of countries that did so was four.

Exchange rate
Rupee Vs US Dollar: How the Exchange Rate is Determined and Its Impact

All of us have seen 20% increase in the value of dollar against rupee within a year and it is fluctuating these days within a small range. Someone has asked in the comments section about what determines the exchange rate and how it is fixed and I would like to provide some of my thoughts in relation to that.

What determines US Dollar exchange rate?

There is nothing extravagant to tell you about this as the rate is determined by market forces just like how the price of goods and commodities is fixed. The value of any currency is based on the demand for it. If the people buy more of a particular currency, value of that currency increases vice versa. The same thing holds true in case of US Dollar Vs INR as well. There are few other factors that play a role in determining the exchange rate particularly when you leave the currency value to the market forces and I will list them below. Growth of the Economy, Inflation, Strength of the Economy including Export and Import, Employment / Unemployment, Government, Public Debt Interest Rates, Sometimes speculation and fear. Again all these factors either increase or decrease the demand for US Dollar or any other currency. If all the factors mentioned above are favorable, people across the world get confident about the stability of a particular country and investment climate, which in turn creates the demand for the currency.

Example: Rupee appreciated significantly in 2006 2007 and the first seven factors I have
mentioned above were the reasons for the Rupee appreciation since India had stable government with favorable economic climate. USA and other multi-national companies started investing in India and they bought more Indian Rupees and the demand for rupee increased which in turn appreciated the rupee value.

What if a country does not have all these?

People will not have confidence in that country and the demand for the currency will come to a halt and then we will see a list of failed nations. Example: Zimbabwe. You might have read in news that a loaf of bread in Zimbabwe cost 1 million Zimbabwean dollar which means nobody values that currency in essence. But what about the eighth factor speculation and fear? Thats what made the US Dollar appreciate 20% versus most of the international currencies in 2008 2009.

US Dollar Appreciation
To recap, I have mentioned that Demand for the currency increases the value of that particular currency. So, what made the people to demand for more US Dollar? Thats where speculation and fear came into play and I list out few points that were responsible for recent US Dollar appreciation. 1. During tough economic times, people get scared and they start moving all their foreign currency assets to more stable currency like US Dollar. 2. US Based Mutual Funds, Hedge Funds and stock investors played a huge role as well. US Funds invested huge amount of money in India during 2003 2007 period, but the funds saw a huge redemption pressure due to the fear of retail investors in US. People invested in mutual funds and hedge funds panicked and started redeeming the units and the Funds were in a huge liquidity crisis. So, they started dumping the Indian stocks and converted all the currency in to US Dollar which created so much demand in a quick time which in turn increased the value of dollar. 3. International currency traders and speculators wanted to take advantage of the rising value and they started buying more and more US Dollar.

Market Forces Vs Central Bank

While most of the countries let the market forces (Demand and Supply) to determine the currency value, some countries like China had fixed currency value for a long time before easing control over it though with a limited scope. Main reason for that was to have a stable balance of payment. Even RBI can regulate the exchange rate to an extent by adjusting the foreign exchange reserves.

Impact of Exchange Rates:

Exchange rates impact in many ways starting from reduced sales for companies to more buying power for individuals. I will explain this with couple of examples.

Exports and Imports get affected

Strong dollar reduces the export value of US Companies and likewise strong rupee reduces the export value of Indian companies. This is what happened in 2007 2008 with Indian companies particularly in IT and Textile sector. Example: Tirupur is the Textile Capital of India and lets take a company called ABC Textiles which makes inners. Assume ABC had agreed to supply 10 inners to Macys in US @ $100 per piece in 2004 when the Rupee value against the dollar was 46. ABC would have earned Rs.46000 in 2004 by supplying 10 inners. But suddenly the Rupee value increased and in 2007 Rupee value was 40 against a US Dollar (You are able to buy 1 dollar by giving Rs.40 instead of Rs.46). ABC would now earn just Rs.40000 for supplying the same 10 inners and it gets affected by reduced revenues. Strong currency makes the imports cheaper. Take another example where KS Oils imports 10 litres of oil from US Company US Oils @ $10 per litre in 2004 when the exchange rate was Rs. 46 Vs US Dollar, which means KS Oils imported 10 litres of oil by paying Rs.4600 (100 * 46). In 2007 rupee value has increased and the same 10 litre of oil now costs KS Oils only Rs.4000. So, exchange rates have its effect on imports and exports.

Buying Power
Assume a traveler from India visited US in 2004 with Rs. 46000. He could have bought goods worth $1000 in 2004. But assume the same traveler visited US again in 2007 with the same Rs.46000. In 2007 he could have bought goods worth $1150. Of course there could have been either increase or decrease in prices of individual items based on inflation or deflation. But the essence is, exchange rates affect buying power as well. I have also uploaded a presentation on rupee appreciation and it would be useful if you want to know more. Readers can access the file at the following link to have additional understanding.

Impact of Exchange Rate on Stocks

As I said above strong currency will reduce the sales and it will have an impact on company earnings particularly when company operates across many geographics. Example: When rupee value appreciated in 2007 - 2008, all the Indian IT, Pharma and Textile exporters faced huge foreign exchange loses and it reduced the earnings and thus the share price. Now, the rupee value against dollar has decreased and all these companies enjoy more earnings due to better foreign exchange rate. Hope I provided a detailed account of exchange rate determination and its impact and look forward to your comments.