By Peter C.Y. Chow
The International Monetary Fund (IMF) decided on November 30, 2015 to include China’s currency, the renminbi (RMB), in the elite basket of reserve currencies that determine the unit value of Special Drawing Rights (SDR). The SDR are used by the IMF to supplement member states’ official reserves. Although the media has touted the inclusion of the RMB as a giant step forward for China’s international economic standing, its symbolism far outweighs the actual significance of the decision.
There are two criteria for inclusion in the basket. First, the country must be a ‘major trading country’. On this point China definitely qualifies: its exports already exceed those of the United States. The second criterion is the currency’s ‘freedom of use’. Any SDR currency should be widely used for the payment of international transactions and traded in major foreign exchange markets.
Rather than asserting that the RMB has become a freely tradable currency, the IMF decision may simply be hoping to position China to commit to further accelerating its financial liberalisation.
There are some misconceptions surrounding the new status of the RMB and China’s role at the IMF. The RMB’s inclusion has nothing to do with the SDR quota and its resultant allocation of IMF voting power. The RMB was accorded a weight of 10.9 percent in the SDR, higher than that of the Japanese yen and British pound. But China’s SDR quota is still only 4 percent, with 3.8 percent voting power.
In comparison, the United States has the largest quota at 17.7 percent with 16.7 percent voting power, followed by Japan with a 6.6 percent quota and 6.2 percent voting power, then Germany at 6.1 percent and 5.8 percent, respectively. France and the United Kingdom both have the same quota at 4.5 percent with a 4.3 percent share of votes.
In the summer of 2015, China liberalised its deposit rate as the first step to encourage competition in its domestic market. But much more deregulation of its financial markets and institutions is needed before China’s currency can be considered freely tradable at the level of those already in the SDR basket.
The IMF’s decision may provide China with some leverage in its yuan-denominated foreign lending. It could enhance China’s ability to facilitate credits for the Asian Infrastructure Investment Bank or offer emergency financial assistance to other governments. But the inclusion of the RMB in the SDR might not affect portfolio management of foreign exchange reserves in central banks. This depends on whether the pledged overhaul of China’s financial systems will materialise.
In view of the interest rate hike announced by the US Federal Reserve Board on December 17 and the quantitative easing adopted in China, the prospect of RMB depreciation is inevitable. The anticipated depreciation may offset the motivation of many central bankers to increase RMB holdings in their foreign exchange reserves. Whether the demand for RMB holdings in the world will increase or decrease is unclear at present.
‘Impossible trinity’
The long-term prospect for the RMB to become a global currency depends, among other factors, on the degree of China’s financial deepening and the easing of its financial markets.
If China further liberalises its capital flows, it will encounter the trilemma of international finance, which N. Gregory Mankiw has described as the ‘impossible trinity’. Essentially, any country in the world can choose to have two out of the three following policy objectives: free capital movement, a fixed exchange rate and monetary autonomy. They cannot have all three. Most OECD countries choose to have monetary autonomy and free capital mobility and are under floating rates regimes.
If China liberalises its capital account and allows free capital flows as the freedom of use criterion dictates, then its current ‘managed float’ system would be subject to scrutiny. China would like to have monetary autonomy after liberalising its capital flows. This would leave a floating exchange regime as China’s only option.
The central bank of China currently lacks independence. For the People’s Bank of China to adjust interest rates, a prerogative of any independent central bank, they must have the approval of the State Council. And the political bureau of the Chinese Communist Party (CCP) must approve any adjustment to exchange rates.
How far China’s liberalisation will go is uncertain. Former premier Zhu Rongji used WTO admission criteria to pursue economic reforms in order for China to accede to the WTO in 2001. Will Zhou Xiaochuan, Governor of the People’s Bank of China, similarly be able to use the RMB’s status in the IMF to engage in far-reaching financial reform in the coming decade?
The first three decades of economic reform in China have not challenged the CCP’s leadership or legitimacy. Rather, in spite of the deterioration of its labour market and the erosion of environmental sustainability, the CCP has been able to justify its legitimacy through economic growth and the improvement of living standards. Financial reform under the prospect of slow economic growth and stagnant labour markets will inevitably affect the interest groups closely tied with CCP leadership. The challenge of financial liberalisation in the near future is much greater than it has been in the past.
The political will of China’s leadership will significantly influence the final outcome of China’s financial reform. Such reform may well lead to serious power struggles within the CCP. For better or worse, the IMF decision may encourage China’s financial system to link with the framework of the capitalist world, but it could also result in a series of unpredictable political developments in China.
(Courtesy East Asia Forum)
(Peter C.Y. Chow is Professor of Economics at the City University of New York)
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