China entered the financial big leagues this week with the decision by the International Monetary Fund to include the renminbi (RMB) or yuan, in its basket of reserve currencies. The decision is both recognition of the increasing role that the RMB plays in international finance as well as a vote of confidence in China’s economic reforms. China is assuming greater weight in the international economy — as the world’s second-largest economy it must — but its economy remains more closed than that of many of the other reserve currencies. The IMF move is intended to nudge China toward further liberalization as much as to reward Beijing’s past performance. It does not, however, signal a vastly increased role for the Chinese currency in the international financial system.
The IMF established special drawing rights (SDRs) in 1969 as a way of increasing global liquidity. At that time, many countries tied the value of their currency to the dollar. But the only way for them to get dollars was to have the U.S. government print more — a process that risked undermining the value of the greenback. The SDR — a basket of currencies that are traded worldwide and will thus be recognized as having value in a crisis — gives member countries access to another ready currency in the event of a balance of payments crisis.
A currency must meet two criteria to qualify for inclusion in the SDR basket: It must be widely used and freely available. By that criteria, the dollar, the yen, the euro and the British pound qualify. An SDR’s value is based on a weighted average of those currencies and is reviewed every five years. The last change in the value of the basket was in 2000 when the euro replaced the German mark and the French franc.
China has pressed the case for RMB’s inclusion since the 2008 global financial crisis, arguing that the world’s reliance on the dollar magnified the impact of such shocks. Beijing policymakers also reckoned that such a change would also diminish U.S. prestige and influence. It formally asked for RMB inclusion last year. After careful consideration, staff economists and the IMF’s executive board recently concluded that China met the two requirements and deserved inclusion in the SDR.
Christine Lagarde, the managing director of the IMF, rightly called the move “an important milestone in the integration of the Chinese economy into the global financial system.” She also noted the decision recognizes China’s progress in monetary and financial reform and prods it to do still more.
There is indeed more work to be done since the decision to include the RMB may be less clear cut than it seems. At first glance, the RMB appears to be widely used. As the currency of one of the world’s largest exporters, the RMB was used for 24 percent of China’s current account transactions in the first nine months of 2015, or about 5.5 trillion yuan. But economists are quick to point out that about 70 percent of international transactions involving the RMB are done in Hong Kong; if you eliminate those trades, the currency is used for less than 1 percent of international transactions, a figure even smaller than the Thai baht.
There are also doubts about the degree to which the RMB is freely available. The authorities in Beijing have maintained tight control over the currency as a way of ensuring tight control over the Chinese economy. A party whose legitimacy derives from continuing economic returns to its citizens cannot afford to hand over its fate to the whims of the market. This imperative has prompted many critics to charge that the Chinese government has in fact manipulated the value of the yuan to maintain competitiveness by keeping its value artificially low.
Late last summer, Chinese authorities allowed the RMB to move more freely against the dollar; its value dropped precipitously in a decision that some called currency manipulation to increase competitiveness as the Chinese economy slowed. Cooler heads interpreted the move as a step toward liberalization and the introduction of more market-oriented valuation. The IMF has accepted that assessment, since it reportedly concluded earlier that the RMB was too tightly controlled to qualify as “freely available.”
China welcomed the IMF decision, adding that it “also means the international community has greater expectations on China to play an active role in the world economic and financial arena.” This will require, among other things, far greater transparency in decision making by the People’s Bank of China than has been the norm.
The IMF decision is an important one and could — and should — provide reformers in China with ammunition to make their case. Still, there remain clear limits on how far the Chinese authorities will go when it comes to letting market forces determine the value of their currency — which is ultimately required for it to be freely available. China’s economy must still develop and the Chinese Communist Party considers its tools — in particular the RMB exchange rate — too important to its own survival to give up. The dollar — and U.S. economic influence — remains powerful. The RMB has joined the SDR basket, but it is a long way away from becoming a true reserve currency.
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