In “Crashing the SDR,” the academic Benjamin J. Cohen, who once worked in the Federal Reserve and has lectured to US diplomats, says the IMF’s decision will set a worrying precedent. “What was once the dignified preserve of obviously elite currencies,” he argues, “could become the site of messy political battles for elevated status.”
The counter-argument is that the RMB inclusion marked the most important change to the IMF’s “Special Drawing Rights” (SDR) basket since its creation half a century ago. Until then, the basket may have been less a dignified preserve than an exclusive club of advanced-economy currencies.
Nonetheless, the SDR crash narrative has been followed by others that associate the weakening of the RMB with its new role as the global currency. In this narrative, as the New York Times puts it, China’s renminbi declined after being named a global currency.
In reality, the U.S. dollar’s strengthening relative to the Chinese RMB began around 2013/14; almost two years before joining the IMF basket and the Fed’s rate hikes – as evidenced by currency charts (see the red oval circle in the Exhibit).
Indeed, the short- and longer-term prospects of the RMB may substantially differ in the foreseeable future.
From the IMF basket to public and private allocations
The RMB graduated into the IMF reserve asset because it fulfilled its criteria. The first requires that the economy represents a major trading nation. Today, China is the world’s largest exporter and second-largest importer right after the U.S.
Another requirement was for the RMB to be “freely usable.” Critics say the RMB is not freely usable because it is not “fully convertible.” Yet, the latter is not necessarily required by the IMF. For instance, Japanese yen was seen as freely usable already in 1978, two years before Tokyo eliminated its foreign exchange controls.
Nevertheless, critics argue that the inclusion will not provide a boost to RMB assets, which Cohen estimates at best around $40 billion in the next few years; a mere drop in over $10 trillion global reserves. However, that estimate identifies the re-weighting of the IMF basket with expected medium-term capital inflows into the RMB assets.
So what might be the full impact of the RMB inclusion?
First, there’s the re-weighting of the IMF basket, which is currently valued at $280 billion and dominated by the U.S. dollar (42%) and the euro (37%), followed by the pound and the yen. The IMF’s newly-adopted rules give the RMB a weight of 11% (instead 14% as initially expected), while the U.S. dollar survives intact (42%), in contrast to the euro (31%) and the rest. Even despite the dollar’s huge incumbency advantages, this seems to translate to some $31 billion into the RMB assets between 2016 and 2020.
Next, public investors – central banks, reserve managers, sovereign wealth funds (SWFs) – would be likely to follow suit, as once with the euro and the yen. If China’s current share of the allocated part of the $11.1 trillion global reserves is 1% and the IMF decision would unleash another 4%, t that could mean $265 billion in RMB assets in 2016-2020.
Finally, private institutional and individual investors would be likely to emulate the moves of the central banks and public investors. If these allocations would rise to just 1% in the next half a decade as some market observers argue, observers that would translate to at least $200 billion into RMB assets by 2020.
Naturally, future is unpredictable and rarely linear. Nevertheless, projecting scenarios based on probabilities is prudent and necessary in the markets.
Moreover, these scenarios could also prove conservative because China’s current share of global reserves may be higher than estimated. Second, total foreign exchange reserves also include some $5.7 trillion unallocated reserves. Third, due to stagnation in advanced economies, investors struggle to gain higher yields, which is increasingly challenging in advanced economies. Finally, investors like to diversify their portfolios in times of risk and uncertainty, which make RMB-assets attractive.
But if that’s the case, aren’t those critics right who argue that the RMB’s (current) weakening suggests its (long-term) depreciation? Not necessarily. The RMB’s short- and longer-term prospects may prove very different – not least because the anticipated impact of the Fed’s rate hikes.
“Hot money” flows and global vulnerability
Recently, the Fed raised the interest by 25 basis points for the first time since the last hike in 2006. Concurrently, it hoped to defuse market tensions by signaling a “gradual” pace of additional rate hikes to come. Nevertheless, stocks tumbled on global worries. Historically, there is also reason for caution and concern. Since the 1980s, rate hikes have reduced U.S. employment and output more than anticipated, while causing collateral damage across the world.
Last time – in 2004-2007 – when Alan Greenspan and Ben Bernanke seized tightening, it contributed significantly to the Great Recession, while contagion spread across the world. Thanks to China’s stimulus-fueled expansion, growth stayed at 5-7% in developing economies. However, as the Fed coupled zero-bound interest rates with rounds of QE, central banks began to drive “hot money” – short-term portfolio flows – into high-yield emerging markets, which were soon struggling with asset bubbles, inflation and appreciation.
Today, U.S. tightening will escalate “hot money” outflows from many emerging markets, which may soon have to cope with asset shrinkages, deflation and depreciation.
As monetary policy divergences guide currencies, the U.S. dollar has strengthened relative to the RMB since 2013/14. Prior to the Fed’s tightening, the People’s Bank of China’s (PBOC) set the RMB’s value against a basket of currencies to expedite capital account reform. In the past, crisis periods caused the PBOC’s basket to serve as a sort of fix against the dollar. In the new basket, the share of the dollar will be lower (26%) than the combined euro and yen weights (35%). With its focus on the nominal effective foreign exchange rate (NEER), China’s central bank signals that it is not pursuing depreciation against U.S. dollar but seeks to complete capital account convertibility.
After the Fed’s rate hikes, the RMB’s weakening is anticipated to prevail over the next 12 months; in part, due to China’s slower 6.5% growth target for 2016-20; in part, due to the “One Belt, One Road” initiatives, which imply more outward direct investment from China. In November, China’s foreign reserves declined by $87 billion, although the total still remains at $3.44 trillion.
The deceleration of China’s growth is only natural after decades of high performance, which has supported the RMB internationalization. What is not natural in the multipolar world economy is the absolute dominance of the U.S. dollar, when America’s relative share of the world economy has shrunk to 22%; it is the world’s largest debtor and finances twin deficits with foreign investments.
In this status quo, global prospects have ample potential to dim further as the countries with enduring high-growth potential (emerging economies) are impaired by the entrenched nations’ (advanced economies) financial hegemony. In times of diminished prospects and crisis, that could unleash a truly global storm.