LAM Kung Shing-A Brief Analysis on RMB's Potential Addition to IMF恠

A Brief Analysis on RMB’s Potential Addition to IMF’s Special Drawing Rights Basket By: LAM, Kung Shing

Introduction

In early 2015, the International Monetary Fund (IMF) Managing Director Christine Lagarde said that it was a question of when, not if, China’s yuan (also known as RMB or renminbi) would be included in the Special Drawing Rights (SDR) Basket. Not only that, in April 2015, the head of the IMF also stated that China’s economic reforms, such as deepening Chinese financial markets and opening up its capital account, could help China meet the IMF’s criteria to be included in the SDR currency basket. While there may be some difficulties for RMB to be added to the SDR, some scholars contend that China’s yuan deserves SDR recognition by the IMF in order to be accepted as a global reserve and to achieve internationalization. The purpose of this thesis is to analyze RMB’s potential addition to the SDR. In order to explore the pertaining issues, it will first present the concepts of the SDR, the potential benefits of RMB’s addition to the SDR for China and reasons why China’s yuan deserves SDR recognition from the IMF as well as the evaluation of China’s odds of SDR inclusion, and this will be followed by what China can do to help RMB be added to the SDR in the future.

The Concepts of Special Drawing Rights

Special drawing rights are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund. Their value is based on a basket of important currencies reviewed by the IMF every 5 years. Based on the latest review conducted in 2010, the SDR basket make-up is as follows: the U.S. dollar 41.9%, the euro 37.4%, the U.K. pound sterling 11.3% and the Japanese yen 9.4%. The weights assigned to each currency in the SDR basket are adjusted based on their 1

respective current prominence in terms of national foreign exchange reserves and international trade.

Despite the fact that SDR nearly play no role in private finance and trading, they serve as the unit of account of the IMF and a medium for allocation of assets among member countries. On top of that, SDR provide the IMF’s approval that a currency possesses the qualities of an international reserve currency. Therefore, SDR currencies can be considered as acceptable reserve currencies while others must meet specific criteria to achieve complete convertibility in order to have the same status as SDR currencies do.

Currently, the vast majority of global currency reserves consists of the 4 SDR currencies mentioned above. Consequently, global financial transactions and international bond markets are dominated by them. In fact, the Chinese government had campaigned for yuan’s addition to the SDR in 2010. However, the bid was rejected at that time. Recently, the IMF has been assessing whether RMB can be included in the SDR basket again.

The Potential Benefits of RMB’s SDR Inclusion for China

There may be several significant advantages for China if RMB can be added to the SDR. Since SDR currencies can be seen as acceptable reserve currencies, the potential RMB’s inclusion in the SDR currency basket will probably help RMB become more international and achieve the global reserve currency status. As a result, overseas expansion of Chinese companies can be facilitated. On top of that, foreign exchange risks resulted from pricing important goods like iron ore in U.S. dollar can be reduced if these major commodities can be priced in RMB.

Most importantly, China may be able to use a part of its tremendous foreign exchange reserves to develop the economy. At present, many foreign exchange 2 resources are tied up in treasury bills and currency deposits. As China takes the initiative to construct infrastructure with other countries, these foreign exchange reserves could be deployed to facilitate different kinds of economic development plans including ‘One belt, One Road’ and ‘New Silk Road’.

Reasons Why RMB Deserves SDR Recognition

The international role of RMB has been expanding in the global trade. RMB is currently the world’s fifth most-used payment currency, according to the Society for Worldwide Interbank Financial Telecommunication, and nearly 30% of China’s total commodities trade is done in RMB now. In addition, China has already been the world’s biggest trading country in terms of the sum of national imports and exports.

Secondly, there have been significant progress in RMB’s onshore and offshore markets. For the onshore market, capital account liberalization has been being tested in the Shanghai Pilot Free Trade Zone. For the offshore markets in Hong Kong, London and Singapore, a great variety of financial products and RMB hedging as well as access to raise capital in the ‘dim sum’ bond market worth RMB 750 billion are provided.

Not only that, foreign investors gradually gain easier access to China’s bond and stock markets. The liquidity and depth of RMB foreign exchange market have been increased.

Another point is that RMB has already been a recognized currency for many reserve managers. In fact, more than 60 central banks in the world have invested in RMB assets with approximated holdings of over US$100 billion. And according to the People’s Bank of China (PBoC), RMB currently ranks the seventh in reserve holdings worldwide.

Evaluation of China’s Odds of SDR Inclusion

A number of recent reports about RMB’s internationalization are optimistic. According to Standard Chartered analyst Robert Minikin, an exceptionally strong case for reserve allocation to CNY assets have been observed, and China, which is a major trading counterparty, possesses the world’s largest foreign exchange reserves. On top of that, China’s markets are deep, its internal and external balances are strong while its currency has a negative correlation to broader asset-market volatility and its assets are also highly rated.

As shown in Figure 1, the offshore RMB market has grown 21-fold since 2010. Hong Kong was the only offshore RMB market in 2010 but there are currently 7 different locations of offshore RMB markets across the globe. This indicates that the use of RMB in cross-border transactions has expanded significantly. The wide use of RMB can enhance investment flows and bilateral trade since it can decrease conversion costs of currencies and risks of exchange rate. Figure 1 Figure 2

According to the IMF, there are 2 important criteria for the SDR selections of currencies. The first one is the size of the nation’s exports. Obviously, China, the world’s largest exporting country, can fulfill the first requirement. The second one is whether its currency is freely usable. When it comes to the second criteria, China’s

situation becomes different. As shown in Figure 2, the ‘freely usable’ criterion consists of ‘widely used’ and ‘widely traded’. A recent report by Morgan Stanley concludes that China will not pass the technical review if the 2010 requirements are unchanged. Nevertheless, Morgan Stanley still believes that there is a good chance for RMB to be added to the SDR basket as the IMF may place more importance on the enormous sizes of China’s GDP and exports as well as the important use of RMB as a payment currency in the Society for Worldwide Interbank Financial Telecommunication (SWIFT) system. Not only that, Morgan Stanley speculates that even though RMB cannot be included in the SDR basket by the end of 2015, the IMF may hold an inter-meeting review before 2020 if there are only a few specific requirements blocking RMB’s way to become another SDR currency.

On the other hand, A Standard Chartered report contends that China has already meet both conditions of ‘freely usable’ and thus should be able to pass the technical review of the IMF if no new requirements are added to the criteria in 2010. And yet, Standard Chartered gives RMB a 60% chance of being included in the SDR basket in 2015.

What China Can Do to Help RMB Become SDR Currency in the Future

China can keep easing restrictions on cross-border investments and opening up the nation’s capital account. RMB’s convertibility is a major concern for its potential inclusion in the SDR basket. At present, the authorities still impose strict foreign exchange controls on personal capital transactions and foreign investors still do not have enough access to China’s domestic capital markets. Therefore, China should allow RMB to have more convertibility. For example, Zhou Xiaochuan, the governor of the PBoC, recently vowed to launch a number of reforms in 2015 such as allowing individuals to invest overseas markets directly.

Conclusion

Although RMB is not a fully convertible currency, it is obviously moving in that direction. And it should be noticed that China has done a lot, including liberalizing its capital account, trying to get more and more other countries to use RMB as part of their global reserves and expanding the use of RMB in cross-border transactions, in order to seek inclusion in the SDR. It is also clear that RMB has become a very important international currency. According to Pieter Bottelier, a senior adjunct professor of China studies at the School of Advanced International Studies of the Johns Hopkins University, it is important to recognize the importance of China in the global economy and that of RMB, adding RMB to the SDR basket will be the right decision. During the process of internationalization of RMB, including RMB in the SDR will probably be a symbolic milestone which can encourage China to further open its capital account and make RMB become even more freely usable.

References

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