Body
Is the Chinese renminbi (RMB) a freely usable currency? Most participants in international financial markets would say no, for several reasons. The government of China exercises tight limits and substantial oversight over the extent to which foreign investors can buy RMB and purchase claims on China. Chinese investors face similar restrictions on the extent to which they can use their RMB and invest abroad.
But assessments by market participants are not relevant to the question of whether the International Monetary Fund (IMF) in November declares the RMB to be a freely usable currency as that term is defined in the IMF Articles of Agreement and is applied to official rather than private transactions. The IMF executive directors must decide whether the RMB is a freely usable currency in order to decide to include it in the basket of currencies used to set the value of the special drawing right (SDR), an international asset issued by the IMF, and what RMB interest rate to use if the Chinese currency is to be included in the basket.1
On August 4, 2015, the IMF, to its credit, issued a meticulous, comprehensive background paper reviewing the method of valuation of the SDR. It did not reach a conclusion or recommendation, but my reading of the IMF staff paper is that the RMB is not sufficiently usable to be included at this time in the SDR basket. A decision on the composition of the SDR basket is expected in November 2015 and to be implemented on September 30, 2016. The decision will be based on the facts provided in an update of the IMF staff paper and the judgment of the executive board on that occasion.
Unfortunately, in my view, the discussion of this issue has become excessively politicized, in part, because Chinese authorities have been waging a well-publicized campaign to have its currency included as a way of recognizing China's emergence as a global economic power and, in part, because the United States and other countries have been using this decision as leverage to encourage financial reform in China. The IMF must be careful to ensure that its decision is based on the facts, and not political pressures, to avoid damaging its reputation.
An argument in favor of including the RMB in the currency basket is that it clearly satisfies what the IMF staff calls the “gateway criterion” for such inclusion. As was the case five years ago when the composition of the SDR basket was last considered, China's share in global exports on average over the past five years ranks it third behind the euro area and the United States and at double the shares of Japan and the United Kingdom. Korea is 1.7 percentage points further behind, followed by Singapore, Canada, Switzerland, and Russia.
But the criteria for inclusion in the SDR basket also require that a currency is freely usable, as defined in the IMF Articles of Agreement (Article XXX (f)), if it “(1) is, in fact, widely used to make payments for international transactions, and (2) is widely traded in the principle foreign exchange markets.” To be freely usable for official transactions, a currency does not have to be fully convertible on all international financial transactions.
The IMF staff paper presents the facts on four traditional indicators of currency use and extent of trading along with five supplementary indicators. The paper also discusses issues with respect to the RMB's meeting the IMF's operational requirements. Based on the evidence provided in the IMF staff paper, my reading is that the facts presented do not present a positive case that the RMB is in the same league as the four other currencies now in the SDR basket. The RMB ranks with three other currencies, the Australian dollar, the Swiss franc, and the Canadian dollar, on most of the indicators, but these are not freely usable currencies for IMF purposes. For the RMB to be included as a freely usable currency, it should consistently rank among the currencies currently in the basket on several of the indicators. The IMF staff paper reports that the RMB may meet this test for only one of the four traditional indicators and probably does so for one of the supplementary indicators.
The paper presents information on three traditional indicators of whether the RMB is widely used: its share of international reserves, international bank liabilities, and debt obligations. On the first, China reported that at the end of April countries held $107.4 billion of their reserves in RMB assets. If all these reserves were held by countries that report to the IMF's Currency Composition of Official Foreign Exchange Reserves (COFER) system, their share would be 1.7 percent less than the shares of the Australian and Canadian dollar and half the shares of the Japanese yen and UK pound sterling. The share of all reserves would be only 0.9 percent. On the supplementary indicator of all official foreign currency assets, the RMB's share is only 1.1 percent, putting it behind the Australian and Canadian dollar as well as the other currencies now in the SDR basket. As an aside, China does not now participate in providing data on the currency composition of its own reserve holdings to the confidential COFER system. It has only promised to join the less-demanding Special Data Dissemination Standard by the end of the year. One might think that if China aspires to big league status for its currency, it would have long ago begun participating in both programs.
The RMB's share of international bank liabilities, a traditional indicator of the use of a currency, could be in the range of the Japanese yen or Swiss franc, but available data are difficult to compare. On its share of international debt obligations, the RMB ranks eighth, but on the supplementary indicator of debt issuance it ranks sixth behind Australia. On one supplementary indicator, the share in SWIFT (Society for Worldwide Interbank Financial Telecommunication) cross-border payments, the RMB ranks eighth behind the Swiss franc and the Canadian and Australian dollar. But on SWIFT trade finance transactions, the RMB ranks ahead of two currencies now in the basket, the yen and sterling—which is not surprising given China's share in world trade and the fact that Asian trade is more likely to be financed by this type of transaction. (This second indicator may be biased somewhat in the other direction by omitting the international transactions of Hong Kong and Macau.)
Under the heading of widely traded, the RMB ranks eleventh with respect to 2013 spot turnover in international markets and ninth in terms of total turnover (behind the Australian dollar, the Swiss franc, Canadian dollar, and Mexican peso). In a partial updating of these estimates to 2014, the RMB moves past the Mexican peso.
Even in the refined and updated form likely to be presented to the executive board in three months, the basic picture is unlikely to change: The RMB is not yet in the league with the other IMF designated freely usable currencies , which are the only currencies now included in the SDR basket. In its review of this statistical information, the IMF staff paper emphasizes the positive trend for the RMB over the past five years. The question facing the IMF executive board in November will be whether it should make a decision based upon an implicit projection of this trend or wait until the projection is realized.
The IMF executive board will have other, in some respects more serious, technical issues to consider in November, however. Does the RMB satisfy the operational requirements of the Fund and its members associated with a designation as a freely usable currency? A freely usable currency plays a special role in members' transactions with the IMF and in their own reserve operations because members can expect to receive that currency in borrowing from the IMF and to use it in repaying the IMF. They should not be disadvantaged in receiving RMB rather than any other freely usable currency from the IMF. Three issues must be resolved to meet any operational concerns.
First, the exchange rate for the currency must be established at the same time as the exchange rates for the other SDR currencies for the purpose of valuing the SDR. That now takes place in London, where there is some trading in RMB. New York and Frankfurt are backups. The problem is that there is no primary trading in New York and only limited trading in Frankfurt.
Second, the reference rate for the RMB must be market determined. But the spread between onshore and offshore RMB exchange rates can be significant. The People's Bank of China (PBoC) has said that it is prepared to provide backstop liquidity to any offshore market to minimize the spread, but it is debatable whether reliance on such a mechanism is consistent with having a market-determined exchange rate.
Third, the interest rate on a short-term asset in a currency in the SDR basket that is used to set the SDR interest rate must be determined by market force in a liquid market. Moreover, the asset should be available to reserve managers who also have the opportunity to hedge their exposures.
In these three areas, the RMB's status is problematic because of restrictions imposed by the government of China and the underdevelopment of its domestic financial market. These impediments may not be definitive and may be relaxed before November, but at present they should give borrowers from the IMF pause about supporting the inclusion of the RMB in the SDR basket.
Two features of the Chinese foreign exchange trading and investment regime are particularly troubling.
First, active trading in the RMB is currently limited to a group of Asian markets, a smaller group of European markets, and two American markets in Canada and Chile. In the 17 markets where there is primary trading of RMB, it is associated with a designated Chinese government-owned clearing bank. In all but two markets, there is a swap arrangement between the PBoC and the local central bank. The exceptions are Taiwan, the Province of China, and Macao SAR.
European central banks with swap arrangements with the PBoC include the Bank of England, the European Central Bank, and the Hungarian National Bank. In the Western Hemisphere, the PBoC has swap arrangements and has designated clearing banks only in Chile and Canada. I do not know why there is no designated clearing bank in the United States to facilitate trading in RMB, but I suspect it is because the US authorities have not been willing to be party to what is in effect a nonmarket arrangement. The question is whether this type of extraterritorial financial support should be viewed as buttressing or weakening the case that RMB offshore exchange rates are market determined. The IMF paper mentions, inappropriately in my view, that these arrangements support the smooth trading of RMB in foreign markets, allowing the inference that this argument strengthens the case for including the RMB in the SDR basket.
Second, on July 14, China opened the door to investments by monetary authorities, international institutions, and sovereign wealth funds in the RMB interbank market, which covers a wide range of domestic financial instruments. But such investors must register with the PBoC and are expected in general to be long-term investors (rather than speculators) and to meet unspecified PBoC macroprudential requirements. These terms and conditions are likely to be met easily by countries that borrow from the IMF and seek to invest or hedge their borrowings, which are likely to be of modest size. It is unclear that all foreign official investors will be willing or able to satisfy the same expectations, however. They might become subject to sudden restrictions or even retaliation by the PBoC if they do not. In other words, it is unclear whether China will fully meet its commitment to open up its market to foreign official investors to say nothing of private investors, who often operate on behalf of official investors.
In summary, in my view, the RMB is not a freely usable currency by the standards of the market or by the narrower standards applied by the IMF in the past for including a currency in the SDR basket. IMF members in November may reach another judgment. Any perception, however, that the IMF is bending its standards for political reasons will do a disservice to the SDR as an international reserve asset and to the integrity of the IMF.
Note
1. The other currencies in the basket are the US dollar, the euro, the Japanese yen, and the UK pound sterling. The value of the SDR is set every five years in terms of a specified amount of currencies, currently four. The interest rate on the SDR is set in terms of a similarly weighted average of the short-term interest rates on assets denominated in these currencies.
