IMF Welcomes China’s RMB Into Exclusive Club of SDR Currencies

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Well first and foremost it isn’t going to happen until October next year, so we are not expecting any short-term impact from the International Monetary Fund adding China’s renminbi to its basket of reserve currencies. Before we go into how this may effect the RMB, what, exactly, has the IMF agreed to and what did China have to do to get itself to this point?

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The IMF confirmed this week that the Chinese RMB would be added to the existing four currencies permitted for the IMF’s Special Drawing Rights (SDR), joining the US Dollar, Euro, Pound Sterling and Japanese Yen, which adjusted the weighting of the last three to accommodate the RMB.

Source: N Y Times

Source: New York Times

SDRs can be held by the central banks of the IMF’s 108 members as part of their official reserves and can be exchanged among governments for any of the (now five) SDR currencies in times of need. The selection of which currencies qualify for acceptance in the SDR basket is broadly based on two criteria: the size of the country’s exports and whether the currency is freely usable.

Making the Grade

As the world’s largest exporter, China’s RMB has clearly qualified on the first count for some years, but failed the test in 2010 on the second being deemed not freely usable. Indeed, as recently as early this year it was failing the second test and, in response to the risk that China would miss this five-year review and fail to gain acceptance before 2020, major and rushed reforms were pushed through this summer.

According to the New York Times, during the summer Chinese officials made a series of rapid-fire moves, most notably devaluing the currency by 4.4% against the dollar as part of a new method for setting the daily trading range of the RMB.

The intention was to give the market more influence over the daily value of the RMB, which is set each morning by the central bank and to counter the claim the currency rate is rigidly controlled by the state. The move was successful, but came at a price that all freely convertible currencies face, namely the uncertainty the country now faces with a more globally oriented currency.

After the devaluation, many Chinese companies moved to pay off foreign debts for fear the RMB would fall further, the NYT reports. Investors also sold huge sums of RMB and switched into other currencies. China’s central bank spent nearly $100 billion in August alone to prop up RMB. Larry Hu, the chief China economist in the Hong Kong office of Macquarie Capital Securities is quoted as saying “Making it more market-based makes it more difficult to manage, but in the end it will also make it more efficient.”

Rating Agencies Weigh In

Moody’s has also been supportive of the IMF’s move, saying in Xinhua News the inclusion would encourage broader use of the RMB in cross-border trade, portfolio investment and debt issuance. Inclusion in the SDR would encourage central banks to invest in RMB-denominated assets, which would potentially stabilize RMB demand, partly offsetting capital outflows at times of higher uncertainty, all of which are positive for China.

In addition the rating agency believes a more open capital account would be credit positive by allowing greater diversification of funding sources for Chinese issuers and greater diversification of investment for Chinese savers.

Taming Beijing

Being admitted as an IMF SDR currency will be both a carrot and a stick to Beijing. A carrot in terms of the political recognition it will bring and lower borrowing costs of having a globally accepted reserve currency, but also a stick in that the economy is still too strictly controlled by the state and further reforms of China’s legal systems are imperative if central banks and major funds are going to accept the RMB on parity to the dollar, euro, yen or pound.

The changes that will be required of Beijing over the coming years will at times be uncomfortable for a centrally controlled communist regime, but if China ever expects the RMB to rival the other SDR currencies they are reforms that will have to happen.

The inclusion of the RMB in the SDR basket will accelerate the use of the RMB in pricing and settlement of international trade and in the pricing of international benchmarks for commodities in RMB rather than US dollars. In reality, we are talking a gradual erosion of the dollar’s dominance not a serious rivalry to the global pricing of trade and commodities in US dollars in the years ahead.

The Chinese are hopeful that within five years one third of global trade will be carried out in RMB. That is optimistic, but Beijing has ever played the long game and gaining SDR approval is one step on the long road to global recognition as the world’s largest and most important economy.

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