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Great Expectations for the Renminbi

Dec 17 , 2015

The International Monetary Fund’s recent decision to add the Chinese renminbi to the basket of currencies that determine the value of its reserve asset, the Special Drawing Right, has captured headlines around the world. But the SDR itself has not exactly dominated discussions – much less transactions – since its creation in 1969. So does the decision really matter?

In fact, given the SDR’s very limited role in the global economy, the move will have few concrete effects in the short term. In the longer term, however, the attention the decision has attracted could spur wider use of the SDR. More important, at least for now, the decision amounts to an endorsement by the IMF of the progress China has made toward renminbi internationalization, while reflecting – and reinforcing – China’s growing economic clout.

Since China joined the World Trade Organization in 2001, its GDP has surged from about CN¥20 trillion ($3.1 trillion) to CN¥60 trillion. In 2009 China became the world’s largest exporter. And last year, according to the IMF, China overtook the United States to become the world’s largest economy (in purchasing power parity terms). The acknowledgement by the IMF board, which represents all 188 of the Fund’s member countries, that the renminbi meets “all existing criteria” for inclusion in the SDR basket is another step forward along this path of progress.

It is important to note, however, that meeting “all existing criteria” does not place the renminbi on par with, say, the US dollar – or, indeed, with any of the other SDR currencies (the euro, the British pound, or the Japanese yen) – in terms of international usage. On the contrary, despite China’s massive GDP and trade volume, the renminbi’s share in the global foreign-exchange market remains negligible. And the process of internationalizing the renminbi is far from complete.

Given this, the IMF could easily have rejected the renminbi’s bid for inclusion in the SDR basket, as it did five years ago. But the IMF seemed eager (especially in the last few months) to bring China on board this time around. What brought about the Fund’s change of heart?

The explanation, I believe, lies largely in the August 11 devaluation of the renminbi, after a decade of appreciation. By moving away from the renminbi peg to the US dollar – an undoubtedly risky move – China demonstrated its willingness to allow market forces to establish the exchange rate in the long term.

Of course, now that the renminbi has been accepted into the SDR basket, China must prove that it can manage dramatic currency depreciation effectively and continue to make progress toward internationalization. This will be no easy feat, especially at a time of slowing economic growth.

A gradual depreciation would create expectations of further exchange-rate weakening, thereby fueling capital outflows and undermining companies’ willingness to use renminbi in exports and imports. The renminbi offshore market, which has strengthened considerably over the last few years, would lose value, forcing the People’s Bank of China to channel foreign-exchange reserves toward that market to offset the decline. Already, China’s reserves have declined considerably – by $87.2 billion last month alone.

Despite these challenges, China’s leaders anticipate that, in the longer term, the renminbi’s inclusion in the SDR basket will help to bring about the currency’s steady appreciation and, by serving as a kind of certification of credibility, support its continued internationalization. They are probably right. Nonetheless, what will really drive the renminbi’s continued rise will not be the SDR (though it will help), but China’s own long-term economic performance. Indeed, as Arvind Subramanian has argued, China’s share of global GDP and trade is what makes the renminbi likely to become a global reserve currency.

The question is when. According to Subramanian, it could occur as early as 2020. Chinese researchers are somewhat less optimistic. Five years ago, Pan Yingli of Shanghai Jiao Tong University projected that, without accounting for other currencies’ incumbency advantage, the renminbi’s share of foreign-exchange reserves worldwide could reach 26% by 2025 (about the current level of the euro). Accounting for the incumbency advantage, the share falls to 10%. But even at that level, the renminbi could be the world’s third reserve currency, after the dollar and the euro, by 2030.

In short, the inclusion of the renminbi in the SDR basket does matter, and not just symbolically. By demonstrating its confidence in the renminbi’s continued rise, the IMF has reinforced global expectations of – and lent implicit support to – the renminbi’s progress toward internationalization. Whatever challenges China faces, its steady march to the forefront of the global economy is set to continue.

Copyright: Project Syndicate

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