- Technically, the renminbi is not yet qualified to be included in the International Monetary Fund’s Special Drawing Rights (SDR). But when taking into account the progress of China’s financial reforms and political considerations, the game may change in Beijing’s favour.
- Despite market hype, the global impact of including the renminbi in the SDR will be minimal. This is because the renminbi is unlikely to receive an allocation in the SDR of more than the 10% individual share that the British pound sterling and Japanese yen each have.
- However, even the prospect of the renminbi becoming an SDR component currency with an increasing weight might create a virtuous cycle for deepening renminbi internationalisation and increasing global demand for Chinese assets for both reserve and portfolio management.
The discussion about including the renminbi in the SDR is not new. People’s Bank of China (PBoC) Governor Zhou Xiaochuan first raised the question on the SDR components when he suggested in March 2010, at a G20 meeting in London, to replace the US dollar by the SDR as the world’s reserve currency. The talk has gained momentum recently, as the International Monetary Fund (IMF) is going to review the components of the SDR basket in November this year. At a press conference on 12 March during the National People’s Congress this year, PBoC Deputy Governor Yi Gang revived the idea of including the renminbi in the IMF’s SDR basket.
SDR, a fast track for the renminbi
The SDR may be a fast-track for the renminbi to elevate its reserve currency status. Currently, the SDR includes four reserve currencies, the US dollar, euro, pound sterling and Japanese yen. There has been speculation that when the IMF reassesses the weightings of these currencies in November, it may add new currencies such as the renminbi to the currency basket.
Contrary to market hype, the direct global effect of including the renminbi in the SDR will not be significant in the short-term, as the SDR accounts for about 5% of global official reserve asset holdings. Currently, total SDR is equivalent to about USD310 billion, with the US dollar, euro, pound sterling and Japanese yen accounting for 42%, 37% 11% and 10%, respectively, in the SDR basket.
If the renminbi were to be included in the SDR, it is unlikely that it would command a share larger than the pound sterling or the Japanese yen. So even if it were assigned a 10% share, central banks’ demand for renminbi via the SDR would amount to USD31 billion only, which is negligible in global terms. After all, the SDR is not a currency, so adding the renminbi to the SDR basket will not have any material impact on international trade and financial transactions.
Technical versus practical considerations
Technically, the renminbi cannot be an SDR component by the IMF’s Balance of Payments definition of a “freely useable currency”. The current four SDR currencies are issued by IMF members (or monetary unions that include IMF members), are the largest exporters in the world, and have been determined by the IMF as freely useable. The latter was added as a formal criterion in 2000 and is open to interpretation, as is the number of component currencies. However, the notion that a freely usable currency ought to qualify for the SDR basket has been intensely debated.
First, it does not strictly mean full currency convertibility. Second, the renminbi has already met some of the conditions for a freely useable currency; notably it has been fully convertible on a current account basis since 1999, and is being increasingly used in international trade settlement and in the denomination of offshore deposit accounts since 2009. According to official data, renminbi trade settlement accounted for almost 20% of all China’s foreign trade in 2014, up from less than 1% in 2009.
Meanwhile, offshore renminbi deposits have grown from virtually zero in 2004 to about 10% of total bank deposits in Hong Kong. They have also been accumulated in other centres, such as London, Singapore, South Korea, Taipei and continental Europe, though in smaller amounts. The PBoC has also signed 25 currency (renminbi) swap agreements with foreign central banks, with the number of agreements expected to increase over time. Lastly, the Renminbi Global Index, which has been developed by a global bank and SWIFT and measures the overall growth in offshore renminbi trade and financial transactions, has reached record highs since its inception in December 2010.
The IMF’s stance
The IMF has kept its flexible stance on SDR component currencies, knowing that the decision of including a currency, such as the renminbi, in the SDR basket is ultimately political. In November 2011, it proposed four indicators for assessing a currency’s potential for inclusion in the SDR. These are (i) trading volume of that currency in spot FX markets, (ii) trading volume of its derivative instruments in the FX and over-the-counter markets, (iii) market-based interest rate pricing mechanism and (iv) currency composition of official FX reserve holdings. However, it has not specified any benchmarks for these indicators, thus leaving the final decision of inclusion to the politicians.
China has likely fulfilled the first condition, and is working on the second one. Interest rate liberalisation is still an obstacle, given China’s slow pace on this development. It is moving ahead nevertheless, with incremental interest rate liberalisation steps since July 2012, including scrapping all bank lending interest rate caps and increasing the deposit rate cap to 30 basis points above the official benchmark rate (from 20 basis points). If the renminbi becomes the third major reserve currency, as we are expecting, in the next few years, the fourth criterion would be met. In a nutshell, the IMF has left itself considerable room to manoeuvre depending on the change in political winds.
The ultimate question
The ultimate question is who decides the issuance and the pricing of the SDR – the IMF? Asia and many other emerging market economies will almost certainly object to that, given the track record of the IMF’s economic prescriptions causing their economies hardship. China may not want to empower the IMF either. That is why in the April 2009 G20 summit in London when Russia proposed an IMF/G20 Working Group to assess the idea of a global reserve currency, there was no input from China at all.
In a nutshell, there is no credible successor to the US dollar as a super global reserve currency in the medium term. No other economies or financial markets are large and deep enough to replace the US as a safe haven during crisis periods. The euro, or even the renminbi, may become an alternative down the road, but that is a long way away.
The long-term impact
Even the prospect of the renminbi becoming an SDR component currency with an increasing weight might create a virtuous cycle where anticipation of deeper renminbi internationalisation (stemming from being an SDR component) would prompt more central banks to hold the renminbi, which would then actually deepen its internationalisation and prompt more central banks to hold more of it. The cycle could snowball and increase the weighting of the renminbi in global reserve allocations to challenge the pound sterling, Japanese yen and the Swiss franc, each currently has not more than 4% of the global reserve allocation.
Global equity and bond indices will also include renminbi assets in their components, so international asset managers will have to include renminbi assets in their portfolios. All this will, in turn, facilitate renminbi international payments for trade and financial purposes. Since major structural changes are needed to fully internationalise the renminbi, the ultimate goal is to use it as a means (an external force) to achieve structural reform success, the end goal of China’s liberalisation process.
Senior Economist, BNPP IP
This blog was originally published for BNPP IP’s professional investor clients. | 1 April 2015 – 4