China’s currency, the renminbi, is about to break the financial world's ultimate glass ceiling when it enters into the currency basket of the International Monetary Fund’s (IMF) special drawing rights (SDRs) on October 1. It will become the first emerging-market currency that can be used to settle IMF credits and debts, joining the dollar, euro, yen, and pound. While in the short term the move is more symbolic—few financial fireworks are expected when markets open on Monday, October 3—it underlines the emergence of China as a major global financial player.
SDRs have a long and complex history. They were originally seen as a solution to dwindling reserves under the Bretton Woods fixed exchange rate system. As the world economy grew and trade exploded, there was an increasing concern that the amount of dollars and gold (to which the dollar was fixed) were inadequate compared to the growing need for reserve assets. Accordingly, when SDRs were first created in 1969 they were defined in terms of dollars and gold. After the Bretton Woods system broke down in the early 1970s, the SDRs value was redefined in terms of a basket involving 16 currencies, only five of which were allowed to be used to settle IMF transactions (the IMF does its accounting in SDRs). Later the basket was simplified to these five currencies, and that is how it has stayed ever since, except that the euro replaced the deutsche mark and the French franc in 1999. While the initial plan for SDRs to become a major reserve asset floundered as governments thought twice about allowing the IMF to issue large amounts of international money, being in the SDR basket remains a potent symbol of a country’s global financial importance.
Joining this elite group is good for China, as it puts the country on the way to realizing the major role in the global financial system that its rapidly expanding economy deserves. China is already a heavyweight in global trade, but the renminbi is less important in financial transactions, partly because China has been cautious about opening up domestic markets to overseas investors. Inclusion in the SDR underlines the long-term goal of achieving such openness, which is (appropriately) proceeding at a gradual pace given that opening up too rapidly has led to financial instability in some other countries. But without an anchor, gradualism always runs the risk of getting bogged down and never reaching the finish line, particularly given concerns about domestic financial overheating. Inclusion in the SDR provides the anchor that the reform process will eventually lead to open capital markets—just as in Hong Kong—and to exchange rate flexibility and eventually a float. As liquid financial markets for the renminbi develop, Chinese assets will become a larger part of the global financial system, including for international reserves.
The inclusion of the renminbi in the SDR is also good for the rest of the world as it democratizes the global financial system. For too long the system has involved a dichotomy between rich and poor nations, with the rich lending through their domestic financial institutions to the poor, often in rich country currencies. Rapid financial inflows and even faster outflows of foreign money have often created instability in the poorer emerging markets, even as their economies have become increasingly important in the global economy. Adding the renminbi to the list of major international currencies gives China an additional financial anchor commensurate with its enormous economic clout.