Does the Renminbi’s Elevation to Global Currency Matter?

There’s symbolic weight in the International Monetary Fund’s approval of the renminbi as the third largest currency behind the U.S. dollar and the euro (but ahead of the yen and pound sterling) in its Special Drawing Rights (SDR) basket. The move reaffirms China’s new-found importance in the global economy. But the practical significance is small, since in order to establish the Chinese currency in the SDR, central banks will need to buy just $30 billion of renminbi assets over the next nine months—an amount less than one day’s trading on the Shanghai foreign exchange market. Some have claimed that SDR inclusion will trigger a huge shift of global reserves into renminbi. This is improbable, at least in the next few years. The renminbi’s share of global reserves today is around 1 percent (compared to 60 percent for the dollar and 30 percent for the euro), and its financial markets are illiquid and poorly regulated, making it unlikely that central banks will want to risk large-scale holdings there any time soon. A gradual rise in the renminbi’s global reserve share to match those of the yen and pound (3-5 percent) over the next five years is plausible; anything beyond that is not.

The bigger question is what SDR inclusion signals for China’s domestic financial reforms. It is important to understand that the main reason Chinese economic reformers sought SDR inclusion was not, as many media reports inaccurately suggest, a desire to make the renminbi a major global reserve currency. Rather, it was to force the pace of China’s own financial deregulation. The strategy copied the use of entry into the World Trade Organization in 2001 to speed up domestic market reforms. In order to qualify for SDR entry, China had to complete the liberalization of interest rates, and adopt a more flexible exchange-rate mechanism that will free the renminbi from the U.S. dollar (to which it has been tethered since the mid-1990s). Reformers also hope that they now have the space to tear down most of China’s remaining capital controls, which make it hard for investors to take money out of the country. In theory, once Chinese financial institutions face the real possibility of losing investors to overseas markets, they will be forced to seek out investments that deliver a higher long-run return. The resulting improvement in capital allocation, it is hoped, will raise the productivity of China’s economy.

This strategy carries some risks. In some previous cases of financial deregulation—notably, in the U.S., in the 1980s—-financial institutions responded to pressure by loading up on high-yielding assets regardless of their safety. If Chinese institutions do the same, the result will be a major financial crisis. Regulators in Beijing presumably believe they have the tools to forestall such a crisis. We must hope they are right.

The latest big news about China is of course the RMB’s inclusion in the SDR. This is symbolic in terms of actual RMB internationalization as far as the outside world is concerned, as not many people have ever heard about the SDR. But, for China’s domestic politics and policy making, this symbolic step is treated as a big deal and of great importance because it is encouraging the reformers to push for more capital account liberalization and more opening up of China’s financial system as well as possibly other reforms. In this sense this is a major win for the reformers. (Just imagine how the Chinese reformers would have been undermined and become less influential if the SDR inclusion had been rejected.) For domestic Chinese politics, this is a valuable step in the right direction as outside pressure has always been necessary for key domestic reforms.

Having said that, we are of course far away from seeing any major fundamental structural reforms such as deregulation, privatization to cut the SOE share, and really shrinking local governments’ economic/business roles, to name a few. For such structural reforms to take place, many more things need to happen beside the SDR inclusion, especially including a change of direction in political ideology (i.e., a reversal of Xi’s reversal of Deng’s reversal of Mao’s ideology and values). But these changes are totally out of the question for now. Thus, only tactical and technical reforms are feasible in the near future (i.e., “abstract” reforms that do not explicitly touch the “Red Line,” such as exchange rate liberalization, some capital account liberalization, and financial market reforms, where “Red Line” means any reform that challenges the official ideology, such as privatization of land or SOE assets, or reforms that eventually undermine the Party’s control).

We can see why fundamental reforms are out of the question if we follow the quick logic chain: maintaining the Party’s absolute control of economy/society is priority #1, far above and beyond everything else, for the current president —> SOEs must dominate economy —> banks and financial institutions must be controlled to serve the party and SOEs —> market principles must be restricted and capital in/out-flows cannot be free —> fundamental reforms continue to be talked about but not implemented, and structural imbalances cannot be corrected.

If the SDR inclusion had happened three or four years ago, more real reforms would have been possible. But, right now, too many burning challenges and downturn pressures are at hand (e.g., overcapacity, capital outflow pressure, difficulty to achieve growth target even after many policy interventions, pollution and environment, all financing tools/channels exhausted to the limit and beyond). So, short-term goals are far more dominating, making the SDR story more of a transitory news event. Reality will be back soon.