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If, 20 or 30 years from now, central banks and sovereign wealth funds hold a significant portion of their reserves in renminbi-denominated assets, financial historians will probably look back on 2015 as a turning point.
The International Monetary Fund is engaged in a year-long review of the currency composition of its special drawing rights (SDR), with a final decision expected between November and early 2016. The currencies now included in the SDR “basket” are from the world’s most influential economies: dollars, euros, yen and sterling.
If the fund decides to add the renminbi to the SDR basket, it will amount to an assurance to global central banks by the world’s foremost financial technocrats that renminbi assets are safe.
For China, inclusion in the SDR would also symbolise the arrival of its currency on the world stage alongside those of the world’s richest countries. National leaders would see it as a sign of respect for China’s increased influence in the world economy and the reforms it has taken to integrate itself with the global financial system.
“SDR inclusion could be interpreted as international recognition of China’s increased economic importance and role in global financial markets,” says Zhu Haibin, chief China economist at JPMorgan Chase.
The direct impact of SDR inclusion is almost negligible. The IMF created SDRs in 1969 to respond to a global shortage in viable reserve assets under the Bretton Woods system of fixed exchange rates. But Bretton Woods collapsed less than a decade later and today various currencies not included in SDRs, such as the Swiss franc and Australian dollar, are also widely held as reserves.
“While it appears to be a contentious issue, the Rmb’s inclusion in the SDR has little tangible and immediate economic benefit for China. The SDR is rarely used by the global financial markets and no country would manage foreign exchange reserves modelled by the SDR,” says Li-Gang Liu, chief greater China economist at Australia and New Zealand Banking Group.
But inclusion into this elite club would have real-world consequences. Every IMF member holds at least some SDRs. Thus, the inclusion of the renminbi would mean that these countries would suddenly be holding renminbi, albeit indirectly. With that threshold crossed, central bank renminbi holdings could be poised to increase rapidly.
Though there is no formal application process to join the SDR basket, China has clearly stated its desire to be included as a result of the five-yearly review now under way.
Wei Yao, China economist at Société Générale who assesses the renminbi’s chances of inclusion at about 50 per cent, says: “China, as the biggest exporter in the world, passes the first test with flying colours. It is more debatable whether the renminbi meets the second criterion.”
The main sticking point is Chinese capital controls, which severely restrict buying and selling of renminbi for investment purposes. Progress on so-called capital-account convertibility will be an important factor in the IMF’s decision.
The launch of the Shanghai-Hong Kong Stock Connect last November marked an important step towards allowing freer cross-border flows of renminbi — known as capital-account liberalisation. But the programme is still subject to a quota that caps foreign investment to a tiny fraction of overall market capitalisation.
Access to the bond market is an even greater obstacle, as bonds are the favoured assets for central bank reserve managers. China took an important step towards free usability in July, however, when it announced that central banks and sovereign wealth funds no longer needed preapproval to buy into the domestic bond market. But non-official investors such as mutual funds and individuals remain subject to quota and licensing restrictions.
“The announcement shows that the PBoC’s determination for capital-account liberalisation has not been deterred by the stock market volatility . . . and that the central bank is still promoting the renminbi’s inclusion in the IMF’s SDR basket during its next review,” said Jianguang Shen, China economist at Mizuho Securities Asia.
The IMF has never adopted specific metrics to determine whether a currency is “freely usable”, giving the fund’s executive board considerable flexibility. However, unofficial IMF working papers suggest that the fund considers whether the renminbi is, in fact, widely used for financial transactions at least as important as what regulations appear to permit or forbid.
“Capital-account convertibility is not a precondition for SDR inclusion. For instance, the yen was included in the SDR basket in 1973, but Japan liberalised international capital flows only in 1980,” says Mr Zhu.
In this regard, the fact that 60 central banks already hold renminbi among their reserves, according to Standard Chartered estimates, is likely to be viewed as an important indicator of usability. But it remains unclear how the IMF will interpret the fact that many of these central bank reserves are held in offshore renminbi assets, which are not subject to Chinese regulations.
Many other obstacles remain to the currency being “freely usable”. Individuals are still subject to a $50,000 per year limit on converting renminbi to foreign currency and vice versa. China plans to roll out a pilot programme for individual outbound investment this year, but it will still be subject to quotas.
Ultimately, analysts expect political considerations to play an important role. If the fund refuses entry to China, it could deepen the Chinese leadership’s distrust of institutions such as the IMF, World Bank and G20, which it already views as unfairly dominated by the west.
On the other hand, the US is likely to argue that the SDR is an important lever that can be used to incentivise China to quicken financial reform. IMF president Christine Lagarde has said that the renminbi’s inclusion is a “matter of when, not if”. That has led many observers to expect a compromise in which the fund will formally declare its intention to add the renminbi to the SDR — but only once deregulation proceeds a bit further.