On 30 November 2015 the International Monetary Fund’s (IMF’s) Executive Board voted to include the Chinese renminbi (RMB) in the calculation of the value of the Special Drawing Right (SDR) currency basket effective from 1 October 2016. This is another significant marker, albeit largely a symbolic one, of the RMB’s growing importance in the international monetary and financial system. The RMB is already increasingly used to denominate and settle cross-border trade and financial transactions. Beyond this, China aspires for the RMB to become a major international reserve currency. The IMF’s decision is likely to give increased impetus to these developments. However, the RMB still has a way to go before it challenges the global dominance of the US dollar.
The IMF created the SDR in 1969 as an international reserve asset during the period of the Bretton Wood’s fixed exchange rate system. An international reserve asset is an asset held by governments to settle transactions between countries and help balance international liquidity. When the SDR was created it was felt another international reserve asset was needed to support the expansion of international trade and finance. While the subsequent collapse of the Bretton Wood’s system lessened the need for the SDR, it has remained part of the international monetary system. The IMF points out that during the global financial crisis the SDR helped provide liquidity to the global economy and supplemented the official reserves of member countries.
In addition to its role as an international reserve asset the SDR is the unit of account of the IMF and a number of other international organisations (such as the Bank for International Settlements).
The value of the SDR is calculated as the sum of the weighted value of a basket of currencies valued in US dollars. Currently, the SDR basket comprises the US dollar, euro, Japanese yen and the pound sterling. The IMF reviews the composition and weighting of the SDR currency basket every five years.
To be included in the IMF’s SDR currency basket a member’s currency must satisfy two key criteria. First, the value of a member’s exports of goods and services must place it among the world’s largest exporters. In this way the composition of the SDR currency basket is supposed to reflect the countries with the most economic clout in terms of global commerce. Second, a member’s currency must be deemed by the IMF to be ‘freely usable’. To satisfy this criterion a member’s currency must be ‘widely traded’ in the principal foreign exchange markets and ‘widely used’ to make payments for international transactions. The intention is to ensure that the market for the member’s currency has sufficient breadth and depth.
The IMF previously considered including the RMB in the SDR currency basket in 2010. At the time it concluded the RMB satisfied the first criteria but not the second.
In deciding to include the RMB in the SDR currency basket the IMF has given it the third largest weighting behind the US dollar and the euro. The new weightings are the US dollar 41.73 percent; euro 30.93 percent; RMB 10.92 percent; Japanese yen 8.33 percent; and pound sterling 8.09 percent.
The inclusion of the RMB in the SDR currency basket increases China’s standing in the international monetary and financial system. It is recognition of both China’s economic importance and the significant reforms it has undertaken. China is the first emerging market economy to achieve this status.
The decision may give some additional impetus to the development of the RMB as an international reserve currency that is widely held by central banks and the world’s major financial institutions. However, it is important to recognise that China is starting from a low base and there remain significant hurdles to the RMB making this transition.
The IMF has estimated that in 2014, 63.7 per cent of official foreign currency assets (both foreign exchange reserves and other foreign currency denominated assets) were denominated in US dollars, 21 per cent in euros, 4.1 per cent in pounds sterling and 3.4 per cent in Japanese yen. Only 1.1 per cent of these assets were denominated in RMB, which was behind both Australian dollars (2.1 per cent) and Canadian dollars (2.0 per cent).
While China’s economic size and internationalisation of the RMB are important considerations, a range of other factors may ultimately determine the extent to which the RMB develops into a major reserve currency. These factors include China’s macroeconomic policies; the extent to which China adopts a flexible exchange rate and open capital account; and whether China’s financial markets have sufficient depth and liquidity (Eswar Prasad and Lei Ye).
There remains some doubt about whether China will implement the necessary reforms. For example, earlier this year John C. Williams, President and CEO of the Federal Reserve Bank of San Francisco argued that while China was taking important incremental steps towards liberalisation, a transition to completely free and open capital and financial markets is not on the cards. He therefore observed:
‘This, incidentally, is why talk about the renminbi replacing the dollar as an international reserve currency is unrealistic. The role of a reserve currency is to be a harbour during a storm; it’s where people flock when the unexpected happens. As we saw in the financial crisis, as we’ve seen in other crises, the market’s instinct is, when in doubt, go to the dollar. As long as China has controls in place to mediate the free flow of money, the dollar will be the refuge, not the renminbi.’
However, it may be that the IMF’s decision encourages China to continue down the path of ambitious capital and financial market reforms needed for the RMB to fully reflect China’s place in the global economy.