Tea Leaf Nation
Let China Join the Global Monetary Elite
China wants the RMB to join the special drawing rights basket. It’s in America’s best interest not to stop it.
When used together, the words “currency” and “China” typically evoke feelings of disdain or fear, and often are followed by another word — “manipulation.” This phenomenon has been on full display in the wake of the unpegging last week of the renminbi (RMB) to the U.S. dollar, which has resulted in a decline of 4 percent against the dollar. It is not surprising that deep skepticism persists in some quarters to the proposal for the RMB to join the exclusive circle of currencies known as the “special drawing rights,” or SDR basket. President Barack Obama’s administration has said it supports the review process, but it has yet to commit to the RMB’s inclusion when the International Monetary Fund’s Executive Board votes on the matter later this year. Sens. Chuck Schumer and Lindsey Graham have already announced their opposition, tying their critique to China’s misdeeds in cyberspace.
But if the IMF comes to a broad consensus that China has met the minimum conditions to join the SDR, it would be a huge mistake for the United States to try to stand in the way. That’s true for one simple reason: The international community would be getting something for nothing, and, no matter how you count it, that is a good deal.
Despite all of the hand-wringing about the RMB’s potential inclusion, special drawing rights are not terribly special. Some of the current opposition appears to be a result of the misperception that the SDR is a “global reserve currency” and that having one’s currency in the basket is the financial equivalent to being a permanent member of the U.N. Security Council. That would be vastly overstating the SDR’s significance: The IMF created the SDR basket in 1969 as a “supplemental reserve asset” to provide liquidity to countries facing balance of payments crises. Its only role is to serve as a rescue fund for countries suffering from financial crises. Central banks can draw on the real-life currencies that together compose the SDR, which since 1999 have been the U.S. dollar, the euro, the British pound, and the Japanese yen. This gives the impression that the SDR-contributing countries are powerful bankers of last resort, the only thing standing between borrowers and ruin. But they’re not.
Being in the SDR basket affords its contributors no material benefits. The SDR-contributing countries do not get any particular say in how their SDR-contributed funds are used; that is left to the IMF’s Executive Board. Central banks, institutional investors, and speculators are no more likely to hold a currency because it is in the SDR basket than if it is not. Meanwhile, the SDR basket itself is cumulatively worth less than $300 billion, a tiny fraction of global currency reserves, which stood at $11.6 trillion in early 2015.
For all the SDR’s inconsequence, the price China has to pay for the RMB to get into the basket is huge. Including China in the SDR basket will require that China further open its capital markets, which will not only create investment opportunities but also serve as a massive disciplinary tool to further push China to improve its economic performance and the way it governs its economy. Being an SDR member will also further embed China in the current global order, giving it a greater stake in providing public goods to the rest of the community and improving the system, not working against it.
To be accepted for inclusion in the basket, a currency must be both “widely used” and “freely usable.” China can easily check the first box, as it is the world’s largest exporter, and at least a quarter of China’s trade is conducted in RMB. According to the Society for Worldwide Interbank Financial Telecommunication, or SWIFT, the renminbi is now the fifth-most widely used currency in international transactions. It’s the “freely usable” part that’s the rub; currency flows in and out of China beyond trade and foreign direct investment are highly circumscribed. Only a small group of about 300 “qualified foreign institutional investors” have been approved to buy into China’s securities markets; their $100 billion in investments accounts for less than 3 percent of China’s stock and bond markets. As a result of these constraints, the RMB likely accounts for less than 5 percent of turnover in global foreign exchange markets, and central banks outside China hold very little RMB in their official reserves. The People’s Bank of China estimated in June that overseas central bank holdings were only the equivalent of $107 billion, and a substantial portion of that amount is held by the Hong Kong monetary authority. The Middle Kingdom’s currency is peripheral to central banks.
China will also have to open up the two-way currency door much more widely if its currency is to be included. That’s good for the non-Chinese financial community, which would gain far greater access to China’s equity and debt markets, and could attract more Chinese capital abroad. But even gradual reform poses a huge risk for China. Greater financial openness may be just the market medicine China needs to become more efficient and ensure sustained growth over the next few decades. But it also makes China more vulnerable to sudden capital inflows and outflows, which could trigger a crisis if investors either pour money into China, generating inflation, or conversely, lose faith in the Chinese economy, depriving it of oxygen.
Despite these risks, Chinese central bank governor Zhou Xiaochuan has convinced China’s leaders that joining the SDR is both highly prestigious, as well as part and parcel of the much more significant goal of internationalizing the RMB. A much larger proportion of its international trade and investment occurring in RMB would substantially reduce the chance of the balance-of-payment risks China faces by depending on the U.S. dollar. For example, China would never be in Greece’s position of begging for loans from foreign creditors, and the prices of its exports and imports would be less vulnerable to fluctuations in exchange rates. Achieving the broader goal of RMB internationalization will require many of the same steps as preparing to join the SDR basket. But whereas governments, via the IMF’s Executive Board, decide the SDR basket’s composition, investors around the globe will decide the fate of the RMB’s internationalization over a period of years, one transaction at a time.
If the RMB joins the SDR, how much of the basket should it constitute? An informal poll I took of experts suggests current expectations lie far south of what the RMB’s actual weight is likely to be, using the IMF’s own formula for calculation. The true weight may come as a rude surprise to some and potentially complicate the case for China’s inclusion. (Technically, the actual decision over weighting is made separate from and after the decision on whether to include — but the IMF’s method for calculating weight is already available, if obscure, and its recent report on the SDR basket already gives figures for the RMB’s potential weight.) My own efforts to replicate the IMF’s methods show that the RMB would immediately account for around 14 percent of the basket, putting it ahead of the pound and the yen. In fact, had the RMB been included during the last review in 2010, it would have had a 10.6 percent share. And if current trends in exports and central bank currency holdings continue, in 2020, when the IMF is scheduled to again recalculate the basket, the RMB’s share would rise to almost 19 percent:
Despite the shock some may feel, the unexpectedly high weighting of the RMB is no reason to either oppose or put off a decision. Tokyo and London may have their feelings hurt, but the U.S. dollar and euro will still be dominant under any scenario.
To be sure, there is no guarantee China will take the necessary and, in some cases, difficult steps to make the RMB “freely usable” between now and when the IMF votes on SDR inclusion. China has loosened domestic deposit interest rates; started to regularly provide currency holdings information to the IMF; expanded access to its stock, bond, and futures markets; modestly reduced barriers to Chinese households to transfer RMB in and out of China; and, as we saw last week, unpegged the RMB from the U.S. dollar, which should result in the unification of the RMB exchange rate in and outside of China and facilitate hedging against the RMB’s value by international investors. While on the right path, China’s capital account still needs to be liberalized further in order for the RMB to be widely and easily exchanged globally, something China’s leadership recognizes.
Then again, we should not exaggerate what is needed to make the currency “freely usable.” Some suggest that admitting China into the SDR before it fully opens its capital account would mean watering down international standards simply to accommodate a rising China. But the IMF admitted the Japanese yen into the SDR basket in 1980, 12 years before Japan fully opened its capital account. The IMF guidelines and history show that “freely usable” is an ambiguous standard — the very trend toward greater openness of the capital account is itself important. On this score, the signs are pointing in the right direction for the RMB.
If China does what is needed to join the SDR basket, other countries should cheer. When the IMF Executive Board gets together in November, China will need 70 percent of the IMF’s vote, and the United States’ 17 percent voting share is not enough to block the change by itself. The United States would have to persuade several allies to join it, which could result in a showdown that would dwarf the ill-fated tussle over the China-led Asian Infrastructure Investment Bank in early 2015. There, the United States claimed that the AIIB fight was about China going outside existing international institutions to set up a new club that ran by its own rules. In the case of the SDR basket, China is trying to become a more central player in the heart of the existing international system, and it’s willing to pay a high price to do so. That is behavior that the United States should reinforce, not oppose.
If the United States were to oppose the RMB’s entry in the face of broad support, that would validate the charge that the United States is not worried about norms and standards, but simply about protecting its dominance in the face of rising power. The United States might win the short-term battle, but it would unintentionally encourage China to build an off-ramp from the global community and set up its own alternative institutions. All the SDR in the IMF isn’t worth protecting if it results in fragmentation of the global system.
Gao Kainan contributed research.
Table note: 2010 and 2015 figures “without the RMB” are IMF’s own reported data. “With the RMB” figures are CSIS calculations following the IMF formula guidelines and available data, and assumes the existing four currencies remain the basket. If the pound or yen were removed, the IMF reports that the RMB would account for 16 percent of the basket. IMF estimates are based on five-year averages of the relative share of exports and currency holdings by central banks of the currencies that compose the SDR basket. 2020 estimates are based on the assumption that export and currency-holding trends for 2010-2014 continue for the 2015-2019 period.
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