China To Join International Montary Fund’s Reserve Currency Unit

China On Way To Joining IMF’s Reserve Currency Unit

Renminbi could enter ‘magic circle’ through SDR broadening     By David Marsh

The stage is set for the Chinese renminbi potentially to develop further as a world currency by entering the 45-year-old Special Drawing Right, the International Monetary Fund’s composite currency unit used in official financial transactions and reserves.

No decision has been made. But measures already taken by the Chinese authorities to internationalise the renminbi, and a big increase in financial market interest in the currency, increasingly point towards a broadening of the SDR’s composition from January 2016.

This is in spite of the renminbi’s formal inconvertibility, reflecting Beijing’s restrictions on capital account transactions that are highly unlikely to be completely scrapped in the foreseeable future

An additional factor building momentum towards revitalising the SDR is China’s own action to galvanise major emerging market economies towards the reform of world monetary arrangements.

This includes the five nation Brics group’s decision to set up the New Development Bank in Shanghai, partly as a challenge to the Bretton Woods institutions, the IMF and the World Bank.

Inclusion of the renminbi in the SDR basket, although ostensibly a technical step, would confer upon the Chinese unit the de facto standing of a reserve currency, a highly important symbolic development and the first time that an emerging market currency would attain this status.

Chinese entry into the ‘magic circle’ of reserve currencies in the SDR, along with the other components (the dollar, euro, yen and sterling), has already been advanced by a ground-breaking decision announced this month by the UK Treasury.

The British government will issue renminbi-denominated bonds, the first sovereign government to take such a step (apart from the Canadian province of British Columbia), and allow the proceeds to be held in the UK reserves managed by the Bank of England, breaking two long-held taboos for the UK authorities.

The IMF will undertake a technical criteria-based review of the options for widening the SDR in a review next year, with most of the work to be conducted from mid-year onwards and any changes taking effect in January 2016. The main conditions are that a currency in the SDR should be widely used in trade invoicing and should be ‘freely usable’ in international payments and asset management.

Other possible indicators include use of currencies in international debt securities and bank liabilities, and foreign exchange spot market turnover. In all these areas the renminbi, although affected by residual capital account restrictions, has made impressive strides in the last two years.

Next year’s planned review, five years after the last IMF analysis of the SDR’s composition, may touch too on the opportunity for the currency basket to play a greater role in financial markets, for example in denominating bond issues or certificates of deposit.

In view of worldwide interest in the renminbi, repositioning and redynamising the SDR by including a leading emerging market currency could encourage greater interest in SDR-denominated instruments by banks, corporations, asset managers and other institutions around the world. SDR bond issues, which made an entrance in the early 1980s, have never achieved much support on financial markets.

The IMF created the SDR in 1969 as an additional reserve asset (in addition to the main official assets, the dollar and gold, which were then regarded as in short supply) to support the post-war fixed exchange rate system that collapsed only a few years later, in 1971-73.

The SDR’s value was initially defined as equivalent to 0.888671 grams of fine gold – which, at the time, was $1. After the collapse of the Bretton Woods system the SDR was redefined as a basket of currencies. Today it consists of the four main reserve currencies.

The SDR’s aim was to create a potential claim on the freely usable currencies of IMF members through voluntary exchanges between members. Countries with strong external accounts were empowered to purchase SDRs from members with weak external positions.

However, from the early 1970s onwards, flows of private capital rose progressively, and the SDR’s importance gradually declined.

As a result of developments over the next 12 months, it may be able to make a comeback.

China on way to joining IMF’s reserve currency unit – The OMFIF Commentary 29 Sep 2014

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Categories: 7-Financial Economic.