An Important Step for China and the World
On 30 November the Board of the IMF decided to include the Chinese RMB in the Special Drawing Rights (SDR) basket from 1 October 2016. SDR is the unit used in transactions between IMF member states and the Fund. RMB will thus become the fifth currency in this basket of global reserve currencies, joining the U.S. dollar, the euro, the Japanese yen and the British pound.
To be included in the SDR basket, a currency has to fulfill two criteria – it has 1) to be issued by a major trading nation and 2) to be freely usable. Given the rise of China as one of the world’s leading trading countries, it fulfilled the trade criterion already during the previous review of the SDR basket that took place five years ago. Taking into account the increased trading volumes of the RMB in the foreign exchange market, its growing use in international borrowing and the actual and promised reforms aiming at liberalization of China’s capital account, the RMB is now also deemed to satisfy the “freely usable” criterion.
The Chinese currency joining the club of global reserve currencies is certainly a substantial achievement for China. Other than being a matter of prestige, it is likely to result in improved access to financing and lower interest rates for Chinese borrowers. It should also encourage further opening of China’s capital account. The new status for the renminbi can be seen as a reward to China’s top central banker, Zhou Xiaochuan, who promoted reforms in spite of opposition from powerful domestic interest groups. For investors from across the globe it would bring additional investment opportunities at a time of historically low interest rates. However, foreign private investors will be influenced by the extent of further liberalization of capital controls and by greater transparency of central bank operations.
The opportunities also bring with them a corresponding set of risks. In the past financial market and capital account liberalization has often been followed by a foreign-lending driven boom that has resulted in a bust and a painful period of decline or low growth and dealing with the imbalances created. The substantial net foreign assets that China has accumulated as a result of past current account surpluses certainly provide some safety in this respect, but it remains to be seen whether China will be able to learn from the past mistakes of others and avoid committing similar mistakes on its own. Appropriate macroprudential measures are very important in this respect.
China’s policy toward the renminbi exchange rate is another remaining issue. The IMF has urged a movement toward a market-determined exchange rate, but China continues to manage its exchange rate. The People’s Bank of China faces the same policy trilemma as all central banks. Concerning the three policy goals of inflation, the exchange rate and capital flows, the bank can achieve any two of the goals, but not all three. Allowing the RMB to float would allow China to target an inflation rate and have free international capital flows.
Until recently, possible economic problems in China could have affected the rest of the world mainly through the trade channel. For example, decreasing investment volumes in China would result in less demand for investment goods produced by some European Union countries, most notably Germany, which would in turn mean less intermediate exports to Germany from Central and Eastern Europe. From now on, however, developments in China increasingly will have the potential to affect the global economy also through the financial channel. What appears to be a diversification opportunity could also become a source of additional risk.
In addition to the above, it is striking that the inclusion of the RMB in the SDR basket has mainly taken place at the expense of reduced weights of the euro and the British pound while the weight of the U.S. dollar has remained almost unchanged (Reuters). Thus, the rise of China, at least from the financial perspective, is taking place at the expense of a relative decline of Europe while the U.S., at least for the time being, is able to preserve its position. This should be food for thought for European policymakers, which hopefully results in a set of actions to make Europe a more attractive place for business and investment.
Reuters. 2015. IMF gives China’s currency prized reserve asset status. November 30.
Wall Street Journal. 2015. “Yuan’s new status to pressure Beijing.” November 30.