Why the West should welcome Chinese yuan’s inclusion into the SDR
The International Monetary Fund is now conducting a review to consider including the RMB in the basket of Special Drawing Right (SDR) currencies and will make a final decision at the end of the year.
At issue for the review is whether the RMB is a ‘freely or widely used currency’ in trade and financial transactions. Since the last SDR review in 2010, the IMF has been contemplating an explicit criterion-based approach in determining a currency’s eligibility for the SDR basket.
In particular, the focus seems to have shifted to whether a currency can perform as a reserve asset currency. Indicators such as foreign exchange turnover, availability of interest rate instruments, and derivative products for hedging central bank reserves have become important variables for this year’s assessment.
A 100-yuan note bearing the picture of Mao Zedong is seen. The yuan is now the world's 5th biggest payment currency. Photo: Simon Song/SCMP
While the IMF decision in 2010 to reject China’s request to include the RMB in the SDR may have had some valid reasons, the evidence this year could have turned in China’s favour. Since July 2009, China has launched an initiative to encourage the RMBs use in international trade and finance.
Yet whether the RMB achieves SDR status is basically irrelevant – no one actually operates in SDRs. But what is crucial is the status, as it will further drive financial liberalisation in China and that is of enormous import. For both China’s domestic economic health and the structural balance of the global economy, the west should be doing all it can to ensure the RMB is in the basket. It would be counter-productive to thwart it.
The RMB is now the second largest global trade financing currency, the fifth largest global payment currency and the 10th largest foreign exchange turnover currency, according to estimates by Bank for International Settlement in 2013.
Moreover, it is expected more than 30 per cent of China’s trade will be denominated in the RMB this year. The RMB has also been used as an investment currency as more of China’s outbound foreign direct investment and overseas development assistance funds are now conducted in the Chinese currency.
Meanwhile, the vibrant offshore RMB trading centres in Hong Kong and London have allowed both private investors and central banks to hedge their RMB exposure with plentiful instruments.
In concert, these developments over the last five years have already catapulted the RMB into the major league of currencies. The RMB could have received a higher score than the yen if one were to rank whether a currency is ‘freely and widely used’ in trade and finance.
So the RMB has obtained the basic qualifications for being included in the SDR basket.
Still, many western observers may have been surprised by the concerted campaign by the Chinese authorities to seek global support for RMB’s inclusion into SDR.
In early March, the Governor of the People’s Bank of China, Zhou Xiaochuan, stated China would strive to achieve basic capital account convertibility by the year end. He reiterated this policy objective in April at the IMF-World Bank Spring Meeting in Washington, DC.
Although the RMB has been under pressure to depreciate since the fourth quarter last year, the currency has maintained stability in spite of sizeable capital outflows in the first quarter of 2015.
To show China’s solidarity with the strong dollar, Premier Li affirmed in a Financial Times interview he did not think the RMB devaluation would be good for the global financial system.
These public statements and concrete policy actions are all meant to shore up western support for this year’s IMF review.
They have sent an unambiguous message China was prepared for tough structural reforms and slower growth while playing its role as an important stakeholder in the global economy in the hope the west, especially the U.S., will not block the RMB’s inclusion in the SDR.
Yet despite these commendable efforts, the RMB’s inclusion into the SDR has little immediate and tangible economic benefit to China.
The SDR is rarely used in global financial markets as no country manages foreign exchange reserves modelled by the SDR. The RMB will not naturally become a reserve currency for others even after it is included in the SDR. Only the markets determine reserve currency status on the basis of risk, return, liquidity, ease of hedgeing and other market efficiency criteria.
However, China’s reformers believe the RMB’s election to SDR status will have a lock-in effect on China’s capital account liberalisation which will then accelerate domestic financial liberalisation and financial services opening up to the rest of the world. They view China’s SDR inclusion as just as important as China’s accession into the World Trade Organisation in 2001.
Opening the capital account will help integrate China’s financial system into the global one, thus finally completing the transition from a hybrid economic structure to a market-driven one.
Ever since China’s accession into the WTO, the global economy has started to experience significant trade and investment imbalances. Some have attributed the cause of the imbalances to the rise of China’s competitive export industries.
Indeed, China has taken the advantage of the rule-based global trade platform by quickly integrating its abundant, disciplined and inexpensive working age population into the global manufacturing network. This integration has quickly made China the factory of the world and has also accelerated China’s rapid rise as the second largest economy.
Large trade surpluses, together with large inflows of foreign direct investment, have allowed the country to accumulate huge amounts of foreign exchange rate reserves at a rapid pace.
However, the closed capital account has prohibited the RMB exchange rate from adjusting to market forces. The huge reserves have returned to the developed economies, pushing down their yield curves and raising their investors’ risk appetite, thereby leading some to blame China for the causes of a global ‘savings glut’, which in turn sowed the seeds for the 2008-2009 global financial crisis.
Meanwhile, China’s large surplus savings have also fuelled a huge property market boom at home, rapidly diminishing China’s cost advantage and raising a serious concern on the health of Chinese banking sector.
Integrating China’s financial system into the global one thus offers an opportunity for the world to address the global imbalances that have troubled the international economy over the last 15 years.
China’s accelerated domestic financial and capital account liberalisation will allow the country to have a market-driven financial system and its RMB exchange rate will also be determined by the forces of capital flows as well as economic fundamentals.
That in turn facilitates China’s economic rebalancing and allows China’s consumers to take a driving seat for future growth. China’s financial integration into the rest of the world will provide the global economy with an important adjustment mechanism via channels of capital and financial flows.
Given there is little to lose but potentially huge gains, the hurdles set by the dominant shareholders of the IMF to include the RMB’s into the SDR will not serve the western interests well.
Instead, they could potentially delay the necessary capital account liberalisation and domestic financial reform and opening up in China, strengthening the hands of those conservative groups opposing China’s further economic reform and financial liberalisation.
Therefore, the west, led by the U.S., should welcome the RMB’s inclusion into the SDR. History will vindicate that this fall’s seemingly trivial decision by the IMF on the SDR is destined to become a boon for the western world in the long run.
The author is Chief Economist for Greater China, ANZ Bank in Hong Kong. He is also a non-resident visiting fellow at the Peterson Institute for International Economics in Washington DC. He has previously served at the World Bank, ADB Institute, and Hong Kong Monetary Authority. He holds a Ph.D. in economics from the Johns Hopkins University.