The Chinese economy is among the largest in the world, and now the International Monetary Fund (IMF) has recognized Chinese currency as among the most important.
The renminbi (RMB) will join an elite group including the dollar, euro, yen, and pound sterling in the IMF’s “basket” of currencies serving as basis for Special Drawing Rights (SDRs).
As a side note, “renminbi” or “people’s currency” is the official name of the Chinese currency as defined by the Communist People’s Republic of China when it was founded in 1949, and a “yuan” is a unit of the renminbi currency (much like a dollar is a unit of Federal Reserve notes).
An SDR is an international reserve asset created by the IMF in 1969 to supplement its member countries’ official reserves. Essentially, SDRs can be exchanged for freely usable currencies in order to facilitate trade, provide individual nations with a safe way to hold assets, and help nations manage exchange rates. Few goods or services are priced in SDRs. The fees to pass through the Suez Canal are priced that way, but it’s not a common practice. Even so, SDRs are an important aspect of world currency markets. As of November 30, 2015, 204.1 billion SDRs had been created and allocated to members (equivalent to about $285 billion).
The value of an SDR has been based on the exchange rates of the four major currencies noted above for the past 15 years, and as of October 2016, the basket will be expanded to include the renminbi. The weights of the currencies in the SDR basket are based on the value of the issuers’ exports, the amount of reserves denominated in the respective currencies that were held by other monetary authorities, foreign exchange turnover, and international bank liabilities and international debt securities denominated in the respective currencies. Beginning in October 2016, the SDR basket will be about 42 percent U.S. dollars, 31 percent euros, 11 percent RMB, eight percent yen, and eight percent pound sterling. The addition of the RMB did not change the U.S. dollar proportion of the SDR basket from current levels, but instead reduced the percentages of the other three currencies.
The IMF’s directors pointed to the “substantial increase in the international use and trading of the renminbi” and decided that the RMB can now be considered “widely used to make payments for international transactions” and “widely traded in the principal exchange markets.” It is a clear sign of the ongoing integration of the Chinese economy with the rest of the world.
The Chinese government had been working toward inclusion of the RMB in the SDR basket for quite a while. In addition to being a point of pride, the increasing importance of the RMB in the global marketplace helps solidify China’s position as an economic power. The Chinese government has recently established RMB trading operations in Europe and developed RMB-denominated financial instruments and commodities contracts. The value of the RMB has also been allowed to fluctuate to some extent in response to market forces, and an abrupt devaluation which occurred in August sent ripples through world markets and the Chinese economy.
Some worry that the IMF action will dilute the effectiveness of sanctions aimed at reducing human rights abuses or curtailing aggressive military actions or weapons programs. For example, if the West attempts to pressure North Korea to correct human rights abuses through cutting off financial avenues, North Korea can conduct business in RMB and remain somewhat insulated.
Others are concerned about the erosion of the dollar as a medium of exchange and the potential fallout for the United States. However, the most likely outcome for the foreseeable future is that the RMB will become more important on the world stage, but not to the point that it takes over or even seriously approaches the U.S. dollar’s primary role. There are simply too many uncertainties even after significant Chinese financial reforms. In fact, the mere inclusion of the RMB as a reserve currency in SDRs does not mean that banks will choose to hold it as a significant source of liquidity. For that to happen, China must solve its current imbalances and establish an ongoing record of economic and financial reforms. While the acceptance of China’s currency by the IMF is certainly a milestone in the progress of this emerging nation, it is equally a challenge and responsibility to earn a legitimate position in the pantheon of major economic powers.