China’s quest for SDR: much ado about nothing
The possibility of the RMB joining the group of key reserve currencies in the world, as defined by the currency composition of the IMF’s own international reserve asset, the Special Drawing Rights (SDR), has attracted much attention recently.
The SDR, created in 1969, is a product reminiscent of a world of fixed but adjustable exchange rates in which central banks needed to keep liquid reserves, at that time mainly gold and a few widely accepted western currencies. Only a few years later, the first oil crisis led to a collapse of the fixed but adjustable exchange rate system, and the major currencies were allowed to float freely. This new environment, coupled with the expansion of liquidity in global currencies, reduced the need to keep international reserves in central bank vaults and, the need for SDR.
As international reserves in emerging markets began to grow after a number of traumatic experiences such as the Asian crisis, the SDR became almost irrelevant as an international reserve asset: only about 2% of the world’s international reserves are in SDR today. The number of currencies making up the SDR has done nothing but fall (from 20 to 4 ) despite that an increasing number of countries have opted for full capital account convertibility and flexible exchange regimes, making their currencies natural candidates for SDR status, especially for the largest economies. The lack of interest in the SDR is epitomized by the Swiss Franc, which acts as a reserve currency, with about half a percentage point of the world’s international reserves, but is not part of the SDR.
The dormant SDR has been woken up by China’s unprecedented campaign to get the RMB added to the SDR basket. The interesting issue is that, for many analysts, such a strong interest in the SDR explains the decision by the People’s Bank of China (PBoC) to allow some RMB depreciation on August 11 and thereafter. The decision to devalue the RMB should be understood as a move to introduce more flexibility, in line with the IMF’s requirements for a currency to be part of the SDR basket. However, achieving SDR status cannot possibly be so important as to warrant such a drastic change in policy without any prior notice.
China’s loss of competitiveness as a consequence of rapid wage growth and a renewed bull dollar cycle are much more important reasons to understand the RMB devaluation. In any case, even if the goal of SDR status is high enough in the policy agenda to push for financial reform, or is simply as a trophy for Chinese level officials, the question really is whether it makes sense. Although the RMB becoming a true reserve currency could be beneficial for China in the long term, I would argue that there is by no means an immediate need for it and, most importantly, SDR status will not help China to really achieve its goals.
China’s interest in becoming a reserve currency makes good economic sense as long as China has external liabilities that can be denominated in its own currency. This is obviously the case for the US, but China is far from this reality. Chinese policy makers, as good long-term planners, know that one day excess savings may not be enough to absorb China’s financing needs as the population ages. Eventually China will be in a similar situation to the US today and will need to attract foreign savings to finance its already large debt. However, China is still very far from this. On the contrary, it continues to accumulate assets with the rest of the world in excess of its liabilities, and this will continue for a while before rapid aging starts to reduce domestic savings. China will continue to be a net creditor with the rest of the world for a number of years before becoming a net debtor.
This will deprive China from exploiting the major benefit of becoming a reserve currency, – facilitating borrowing from the rest of the world – in the foreseeable future. Obtaining SDR status may put the RMB on the shiny podium of reserve currencies, but it will not ensure that central banks hold additional amounts of reserves in RMB (beyond those required to keep the SDR basket).
This is even more the case for other investors beyond central banks. Their demand for RMB will ultimately depend on two key issues. First, the RMB needs to be able to maintain its purchasing power parity in the medium to long run. Second, RMB onshore financial markets, especially the money market, need to be open and accessible to foreign capital, so that capital controls are not an option. The former sounds possible as long as China maintains its competiveness. The latter needs additional efforts from Chinese policy makers. The good thing is that this does not need to happen overnight, as the benefits of a reserve currency status are to be reaped well down the road anyway. Unfortunately this what China seems to be doing, apparently pushed by the IMF and probably the US. All in all, I have the feeling that a lot of fuss about SDR status has been created, without it being relevant or immediately desirable from an economic point of view. Political aspects, including trophy hunting, are a different matter.
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