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What Price Will China Have to Pay to Make RMB an International Reserve Currency?

Tuesday, August 18, 2015

What Price Will China Have to Pay to Make RMB an International Reserve Currency?

Asia Global Institute's Distinguished Fellow Andrew Sheng considers what China will have to do for the yuan to be part of the IMF's currency basket.

Bankers and financial centers from Hong Kong to London salivate at the trillions of dollars of new trading that will come from the RMB becoming a full-fledged reserve currency. But when will it happen?

One milestone of the RMB becoming a full-fledged reserve currency is to join the club of component currencies of the special drawing rights, created by the International Monetary Fund. Unlike currency issued by central banks, this reserve asset is issued by the IMF to its 188 sovereign members, in exchange for their national currency and other convertible currencies. The special drawing rights can be counted as part of their foreign exchange reserves.

Indeed, member countries may draw on this account if they need more foreign exchange. Normally they may draw up to four times their quota, but the more they draw, the more they will be subject to IMF "conditionality," in the same way your banker imposes more stringent conditions the more you borrow. The Greeks and Asians learnt that when you are subject to an IMF lending programme, you cede quite a lot of national decisions to the IMF, which is why many members shy away from IMF credit.

The special drawing rights were introduced in 1969 as an international reserve asset to supplement global liquidity. They are not a reserve currency in the sense that the markets trade them and you can put a deposit in any bank denominated in them. They are used mainly by central banks to transact with the IMF. For example, accounts of the IMF and the Bank for International Settlements (the de facto central bank of central banks) are denominated in them.

The special drawing rights comprise a basket of only four currencies - the U.S. dollar, euro, pound sterling and the Japanese yen. Being part of the basket is like joining the gold standard, as the currency is considered a full member of the reserve currency club.

Other than prestige, there are obvious benefits from being a member. Data from the Bank for International Settlements showed that central banks held nearly 12 trillion U.S. dollars (excluding gold) at the end of last year, with the U.S. dollar accounting for 62.9 per cent of the reserves, the euro 22.2 per cent, the pound 3.8 per cent, and the yen 4 per cent. In other words, even though there are many freely usable and fully convertible currencies, such as the Australian dollar, the four components of the special drawing rights account for 92.9 per cent of the total central bank foreign exchange reserves.

In other words, if the RMB or any other currency joins the club, demand from central banks alone would add to demand for that currency, making it even more usable and tradeable.

But joining any club has conditions. Last week, the IMF published a paper looking at the conditions for including the RMB. The next decision point for the review is in November, when the IMF executive board meet to review the special drawing rights composition and its valuation.

The RMB was considered for the basket in 2011, but was rejected as a new member because it was not considered "freely usable."

There are two key criteria for entry - the export criterion and the "freely usable currency" criterion. China fulfilled the first criterion in 2011, being the world's third-largest exporter of goods and services. The "freely usable currency" criterion has many legal and technical definitions. To be eligible, a currency has to be "widely used" and "widely traded," which means it is traded in "principal exchange markets;" the currency should be convertible (but not necessarily fully convertible); and it is widely used in "international transactions."

Interestingly enough, "full convertibility" is neither a necessary nor sufficient condition for the definition of a "freely usable currency." If there is sufficient liberalization for the holder of that currency, say, the RMB, to have adequate access to the RMB market to obtain other convertible currencies, it can satisfy the convertibility condition.

There are therefore two hurdles to the RMB joining the special drawing rights club. The technical hurdles have already been laid down by the IMF ‘s diplomatically crafted technical note. They are complicated, but not insurmountable. In fact, they allow more time to assess the issues, which could extend the deadline to September 30 next year.

Although IMF managing director Christine Lagarde said the recent A-share volatility should not affect the technical decision, a background comment by a senior IMF official suggested the IMF would prefer a more free market-determined interest rate and more market-determined exchange rate, plus more transparent data.

The more complex hurdles are domestic and geopolitical. Officially, there is great domestic commitment to the RMB joining the special drawing rights basket, but unofficially, after the recent domestic volatility, there are also comments whether a fully open capital account would add risks to China's reform process. My opinion is that there is no ideal time for opening up, and it really is a question of political will.

The more complex decision is geopolitical. The Europeans, including Britain, have indicated more openness to welcoming the renminbi. But the US and Japan may be more hesitant. The US, which has a de facto veto on the IMF board, will want to extract concessions and conditions on any new entrant. Such conditions may not have anything to do with the IMF, but everything to do with Sino-US relations.

The key, then, is what political price China is willing to pay to join the club. The American comedian Groucho Marx once said that he did not want to join any club that would admit him as a member.

If the RMB does not make it in November, will China play a different game? That is the real question before us.

This article first appeared in the South China Morning Post on August 10, 2015.

The views expressed in this article are the author's own and do not necessarily reflect Asia Global Institute's editorial policy.


Andrew Sheng

Distinguished Fellow, Asia Global Institute

Andrew Sheng


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The University of Hong Kong
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