The renmimbi and the SDR Club

When will that happen?

One milestone on the road to the yuan becoming a bona fide reserve currency would be its inclusion as a component currency of the Special Drawing Rights (SDR), created by the International Monetary Fund (IMF). Unlike currency issued by central banks, the SDR is a unit of account issued by the multilateral IMF to its 188 sovereign members, in exchange for their national currency (not necessarily convertible) and other convertible currencies. The SDR can be counted as part of their foreign exchange reserves. 

Indeed, member countries can draw on the SDR account like an overdraft when they need more foreign exchange. Normally they can 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 being subject to an IMF lending programme means ceding quite a lot of national decisions to the international fund, which is why many members shy away from IMF credit.

The SDR was introduced in 1969 as an international reserve asset to supplement global liquidity. It is not a reserve currency in the sense that the markets trade SDRs and you can put a deposit in any bank denominated in SDRs. The SDR is only 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 SDRs. The SDR comprises a basket of only four currencies – the US dollar, euro, pound sterling and the Japanese yen. Being part of the SDR basket is like joining the gold standard – the currency is considered a full member of the reserve currency club. 

Other than prestige, there are obvious benefits from being a member of that club. BIS data [1] showed that central banks held just under US$12 trillion (excluding gold) at the end of 2014, with the US dollar accounting for 62.9 per cent of such reserves, euro (22.2%), sterling (3.8%) and yen (4%). In other words, even though there are many freely usable and fully convertible currencies like the Australian dollar or Swiss Franc, the top four components of the SDR account for 92.9% of total central bank foreign exchange reserves. 

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

But joining any club requires meeting membership conditions. Recently, the IMF published a paper [2] looking at the conditions for RMB joining the club. The next decision point for the review is November this year, when the executive board of the IMF meets to discuss the five-year review of the SDR composition and its valuation, all of which will depend on how members vote. The last review was done in 2011, when the present four currencies were confirmed as core components of the basket. The RMB was considered then but rejected as a new member because it was not considered to be “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 extensive legal and technical definitions. To be eligible, a currency has to be “widely used” and “widely traded”, which means that it is traded in “principal exchange markets”; the currency should be convertible (but not necessarily fully convertible); and the currency 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 liberalisation for the holder of that currency (say RMB) to have adequate access to the RMB market to obtain other convertible currencies, it can satisfy the convertibility condition, but not other conditions.

There are therefore two hurdles to the RMB joining the SDR 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 for more time to assess the issues, pointing out to a possible extension of the deadline to September 30, 2016. 

Although IMF managing director Christine Lagarde said that 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 political, both domestic and geo-political. Officially, there is great domestic commitment to RMB joining the SDR 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 geo-political. The Europeans, including Britain, have indicated more openness to the RMB joining the club. But the US and Japan may be more hesitant, since both are concerned whether a newcomer could erode their incumbent status. The US, which has a de-facto veto voting power in the IMF board, will want to extract concessions and conditions on any new entrant. Such conditions may not necessarily have anything to do with the IMF, but everything to do with US-China relations. The key, therefore, is what political price China is willing to pay to join the SDR club. The American comedian Groucho Marx once said that he did not want to join any club that is willing to 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. 

 

Andrew Sheng writes on global issues from an Asian perspective.