The International Monetary Fund (IMF) is poised to approve the inclusion of China’s renminbi (or yuan as it is called) as a reserve currency later this month. The implications of that would be several. Above all, it is an acknowledgement by the global community of China’s economic prowess. The world’s second largest economy will have to be given its due place in the global financial architecture.
China’s quest for a reserve status for its currency has for long been in the making. Way back in 2009 senior Chinese monetary officials advocated the replacement of the US dollar as the dominant international currency with a group of currencies administered by the IMF. Such an advocacy —tantamount to a drastic overhaul of the global financial order — seemed too premature at that time and in any case was ignored by the US and other developed countries.
The expectation that the yuan or the renminbi will acquire reserve currency status is no longer a pipe dream. What in 2009 appeared to be, at best a vision, is now very much in the realm of possibility. It will certainly mark a big step for the Chinese currency although opinion among experts seems divided on how significant the inclusion of the yuan in the global currency basket will be.
The prospect of the yuan joining currencies such as the dollar, euro, yen and sterling in backing the IMF’s Special Drawing Rights has been variously described as everything from a symbolic move to the dawn of a new era.
SDRs are the IMF’s unit of account restricted to its members. The SDR basket is the basis of IMF’s lending made up of the world’s most liquid currencies and hence suitable for any member country that needs support for its balance of payments.
When the yuan is formally inducted into the SDR portfolio it will be the first new currency to be so honoured since the euro was created. It effectively becomes a reserve currency.
The important advantage accruing to China is the flexibility in settling all its international obligations with its own currency.
This, in technical parlance, is referred to as “exorbitant privilege”. For other countries, the benefit in having another reserve currency is that they can diversify their forex reserve portfolios to include renminbi. That would once again be a recognition of China’s economic strengths.
Holders of foreign currency reserves have nowhere to go and they necessarily have to hold to hold their reserves in one or the other of reserve currency.
SS Tarapore, a former RBI Deputy Governor and now a columnist, has been pointing out — much before the current focus by the IMF — that the yuan is the obvious candidate for inclusion in the list of reserve currencies ( The Hindu Business line May 14, 2015 ).
The IMF, which does a review every five years (the most recent one was in October 2015) is apparently convinced of the Chinese currency’s eligibility. At the previous review of reserve currencies in 2010 it was felt that China’s exports were not high enough and world trade invoiced in the yuan was not adequately high. Since then there has been a dramatic increase in these parameters in favour of the yuan.
India, along with other countries, stands to benefit from the induction of the yuan in the list of reserve currencies. There are seven reserve currencies — apart from the dollar, euro, pound sterling, Japanese yen, Swiss franc, Canadian dollar and the Australian dollar.
But the world financial order is heavily skewed in favour of the dollar. About 62 per cent of international currency assets are held in dollars. The euro accounts for 23 per cent and yen and pound sterling four per cent each. Induction of the yuan is certainly going to help.
As pointed out in one of our previous columns the dollar’s hegemony brings with it a number of disadvantages.
For example, a miniscule rise in the American interest rate or even a talk about it is enough to cause huge upheavals in the markets of developing countries such as India’s. Second, there are limits to the Federal Reserve’s capacity to meet liquidity shortages in the global economy. The American political system is dysfunctional. How long should financial systems of the world be captive to the vagaries of the U.S. domestic politics?
There could be further arguments that China for all its recent strengths still needs to go further in plugging some gaps in order to bid for reserve status. Chiefly its currency is not fully convertible and it lacks bond markets with depth. It is expected that both these anomalies will be corrected. A very recent report from China talks of accelerated financial sector reforms which will interalia, allow the yuan to trade freely by 2020.
Reserve status will increase the demand for renminbi from central banks. A more weighty consequence would to be to integrate China with the global system and commit it to further reform.
It is for these reasons that the imminent inclusion of its currency is considered to be a momentous event on a par with its joining the World Trade Organisation in 2002.