photo: Ryan McFarland
The IMF will decide this month whether to make the Chinese renminbi the fifth international reserve currency. For the euro, that would not be a win or lose game.
Behind the facade, there has been much debate about the inclusion of the Chinese currency – the renminbi (RMB) – as the fifth international reserve currency.
Initially, Beijing hoped that, after the International Monetary Fund’s (IMF) long-anticipated November meeting, the RMB could be added into the international currency basket by 1 January, 2016.
After China’s growth deceleration, and the boom and correction of its equity markets, the Fund’s experts recommended in early August that the IMF would delay its RMB inclusion until September 2016.
The IMF meeting will take place at the end of November. What will the decision – whatever it will be – mean to the euro?
The IMF inclusion decision will be based on the review of the Special Drawing Right (SDR), which the Fund created in 1969. It is an international reserve asset, which currently includes US dollar, euro, British pound and Japanese yen.
China’s first effort to have the RMB included in the SDR basket took place at the previous IMF Review in 2010. That attempt failed, due to inadequate capital account convertibility. In the era of president Xi and Primer Minister Li, Beijing has made the liberalization of the capital account and the exchange rate a major priority.
The IMF review consists of two steps. The first requires that China is a major trading nation. Well, today, China is the world’s largest exporter and second-largest importer, right after the US.
But the IMF also requires the RMB to be “freely usable.” China achieved full convertibility of the current account already in 1996, but capital account restrictions do remain.
Nevertheless, reforms have accelerated and full convertibility is not necessarily required by the IMF. The Japanese yen was seen as freely usable already in 1978, two years before Tokyo eliminated its foreign exchange controls.
The IMF Review’s second step requires a final vote by the IMF board. That is the political and subjective part of the IMF procedure. In practice, the RMB needs a 70 percent majority in the final vote to become a reserve currency.
Recently, exchange rates have seen massive currency movements. Since mid-2014, the euro is down by more than 10 percent. Nevertheless, as Europe’s cyclical recovery has proved weak, the European Central Bank (ECB) recently announced it was missing its inflation target and was considering new stimulus.
The ECB chief Mario Draghi shuns euro appreciation. When the euro has threatened to appreciate beyond $1.15, the ECB has warned of more quantitative easing (QE). After the IMF’s RMB decision, Draghi will decide whether more QE is needed.
In this environment, the near-term effect of the RMB inclusion in the IMF reserve currency basket would likely be small. It involves the reweighting of the $30 billion SDR basket.
Currently, the US dollar accounts for 42 percent and the euro for 37 percent of the total, whereas the British pound and Japanese yen are about 9-11 percent each.
The long-term consequences of the RMB inclusion would be huge.
An IMF endorsement could unleash a massive, though gradual reweighting of the global $12 trillion reserve portfolio. Private investors would be likely to follow in the footprints, especially as China’s capital markets evolve and liquidity improves.
Let’s assume that the IMF reserve currency basket would include the RMB and that it would be reweighted. If, initially, Chinese currency would be about 10 percent of the total, along with Japanese yen and British pound, then the role of the US dollar would be likely to decrease to 38 percent and euro to 34 percent, respectively.
That would unleash 10 percent of the $11.6 trillion of global reserves – more than $1.1 trillion – could flow into RMB assets.
No win-lose game
Some believe that the RMB’s gain would be the euro’s loss. This stance unites those pan-Europeanists, who want more rapprochements with Washington and less with Beijing, and those eurosceptics, who mistake self-sufficiency with Fortress Europe.
In reality, the rise of the RMB is everything but a win-lose game. From Beijing’s standpoint, a healthy Europe is positive to Chinese exports and direct investment, which is why president Xi recently urged the UK to remain part of the EU.
Second, a healthy euro will support European foreign direct investments and exports in China, which is rebalancing toward consumption. Indirectly, the euro’s strength also ensures that US dollar’s unilateral monopoly in global finance will erode over time.
Third, the strength of the RMB in no way implies that currency advantages will remain in China alone. US and European portfolio managers and individual investors would like to invest more in China’s growth regions and sectors.
But the reverse applies as well. Chinese institutional investors are eager to diversify risk by internationalizing their portfolios, which are still focused on the mainland.
The RMB inclusion is only a matter of time, as the IMF managing director Christine Lagarde has acknowledged. Even if China misses the cut in fall 2015, there is a high likelihood of an interim-meeting review that will grant RMB the SDR status before the next scheduled decision in 2020.