The RMB Joins the SDR: Historic Inch-stone in Global Financial System

By Scott Kennedy

Source: Japanexperterna.se's flickr photostream, used under a creative commons license.

Source: Japanexperterna.se’s flickr photostream, used under a creative commons license.

On November 30 the International Monetary Fund (IMF) Executive Board voted to approve the inclusion of the renminbi (RMB) in their Special Drawing Rights (SDR) basket of currencies. The decision will take effect on October 1, 2016. The RMB’s inclusion is part of the IMF’s standard review of the basket’s composition, which occurs every five years. The move was widely anticipated, particularly since IMF managing director Christine Lagarde on November 13 endorsed an IMF staff report that made this recommendation.

Q1: Did the IMF make the right decision?

Unequivocally, yes. It’s right both on narrow technical grounds and on broader policy goals. To be eligible for inclusion a currency must be “widely used” and “freely usable.” The RMB has long satisfied the first criterion. China is the world’s largest trading country, and currently 25 percent of its foreign trade occurs in RMB. The RMB is now one of the top five most widely used currencies in financial transactions globally. In addition, China has gradually loosened its capital controls for portfolio investment. Global financial institutions have access to China’s domestic stock and bond markets through the Qualified Foreign Institutional Investor (QFII) program, and central banks have been given even more access to China’s securities markets. China has also started to issue RMB-denominated debt abroad. Although Chinese authorities still intervene in foreign exchange markets to affect the RMB’s value through a “managed float” system, as opposed to a fully free float, private investors and governments are able to hedge against the RMB’s value. Finally, China has made its financial system somewhat more transparent by making more data about its foreign exchange reserves and other aspects of its economy available to the IMF and broader public.

More broadly, China has spent most of the past 36 years integrating itself into the global economy and international economic institutions. At the same time, China has recently rolled out new initiatives, such as the Asian Infrastructure Investment Bank (AIIB) and the “Belt & Road” investment plan, that suggest China may be seeking to create alternative institutions to the existing global architecture. These fears are exaggerated, but including the RMB in the SDR basket is another way to further cement China’s interest in the Bretton Woods system. On the heels of the U.S. government expressing deep concerns about AIIB and deciding not to join, saying “no” on the SDR basket would have generated more momentum within China to create alternative institutions.

Q2: How important is the RMB’s inclusion in the SDR basket?

Inclusion is significant for three reasons. The most important is to tie China firmly to the international economic system. Thirty years ago who would have guessed that China’s authorities would place so much stock in having their currency treated with such respect by the IMF, which sits at the apex of the global capitalist order? That reflects a monumental shift in Chinese views about the world and their priorities. The second most important aspect of this story is the range of financial reforms that China has had to make to render the RMB eligible to join. China’s capital account is more open than in the past, and the economy is more transparent. Going forward, SDR entry is not akin to China joining the World Trade Organization (WTO) in terms of new leverage the global community has on China, but the spotlight on China will be even brighter as it continues to carry out economic reforms.

Perhaps the least significant element of the story is the question of whether inclusion in the basket makes the RMB a powerful international currency. The SDR is in principle a global reserve currency of which the RMB is now a component, but there is only the equivalent of $280 billion in SDRs in existence, whereas global foreign exchange reserves stand at $11.5 trillion. China will not be able to use inclusion to pressure developing countries or advanced industrialized economies, nor will it be able to dilute IMF standards regarding the conditions by which it lends to its members facing financial crises.

Q3: Was there anything surprising about the IMF’s decision?

Yes. The IMF simultaneously announced both the RMB’s inclusion and the relative weights of the currencies in the basket. Technically speaking, inclusion in the basket and the relative weight of each component currency are separate decisions. The decision to include is supposed to be made first, and then the decision over weighting is supposed to follow. It appears that the two decisions were made in tandem as part of the negotiations over whether to include the RMB in the first place. The decision reflects the discomfort of some IMF members about the proportion of the basket the RMB would have occupied had the IMF followed its original formula, which put a lot of weight on countries’ trade. IMF members must have been persuaded by the logic that, since over 70 percent of China’s trade occurs in U.S. dollars, it would not make sense to award the RMB a larger weight in the basket as a result of the country’s trading prowess. The new formula puts more stress on financial variables.

 

Pre-Inclusion Weights (2010) Original IMF Formula (2015) New IMF Formula (2015)
U.S. Dollar 41.9 38.7 41.7
Euro 37.4 31.7 30.9
Pound 11.3 7.6 8.1
Yen 9.4 7.8 8.3
Renminbi 14.2 10.9

 

The biggest beneficiary of the revised formula appears to be the United States, which saw its share of the basket barely decline at all. By contrast, the euro and pound had their shares drop the most.

Q4: Does inclusion of the RMB in the SDR basket represent a softening of the conditions in the face of Chinese political pressure?

No. The IMF has repeatedly stated that the standard for “freely usable” is not equivalent to a fully open capital account where there are no constraints on the inflow and outflow of currencies in an economy. Instead, this standard is open to interpretation and is highly affected by both historical and comparative analysis. The Japanese yen was included in the SDR basket in 1980, but it was not until 1992 that Japan fully opened its capital account. And so the IMF is not setting a new precedent by including the RMB before China fully opens its capital account.

Q5: Why is the RMB’s joining the SDR basket so important to China?

For China’s top leadership, the RMB’s inclusion in the SDR basket is a sign of the world’s respect for China and its contribution to the global economy. It is akin to other signs confirming China’s rise, such as hosting the Olympic games, awarding a Nobel prize to a Chinese citizen, or the successful launching of a Chinese space vehicle. For China’s financial technocrats, SDR inclusion is a tool to promote domestic economic and financial reforms and part of a strategy to gradually increase the international usage of the RMB in order to make China’s economy less vulnerable to foreign exchange risks.

Q6: Is demand for RMB holdings likely to spike?

There may be a brief jump in demand for RMB in the wake of the IMF’s decision, but we are likely to see a divergence in activity between official institutions and private investors. Sovereign wealth funds, central banks, and multilateral financial institutions are likely to gradually increase their holdings of RMB in the next few years. Central banks will modify the composition of their official foreign exchange reserves to take account of the RMB’s position in the basket, and organizations such as the Bank for International Settlements, the World Bank, and the Asian Development Bank themselves hold claims on SDRs and are likely to increase their holdings of RMB as well. However, private investors are unlikely to substantially change their holdings of foreign exchange as a result of the RMB’s inclusion in the basket. For them, SDR inclusion is almost irrelevant. Their investment calculus will still be driven by a more market-based logic and be based on factors such as China’s growth trajectory, signs of volatility, and the leadership’s commitment to further liberalization of the economy.

Independent observers believe that at most total holdings of RMB globally may cumulatively grow by approximately the equivalent of $80–100 billion per year. This sounds like a lot, but this would still only be around 1 percent of global foreign exchange reserves and leave the U.S. dollar still as the world’s dominant currency.

Dr. Scott Kennedy is deputy director of the Freeman Chair in China Studies and director of the Project on Chinese Business and Political Economy at CSIS. Follow him on twitter @KennedyCSIS.This piece was initially posted as a CSIS Critical Questions accessible here.

Scott Kennedy

Scott Kennedy

Dr. Scott Kennedy is senior adviser and Trustee Chair in Chinese Business and Economics at CSIS.

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