Reading the Future of the Internationalization of the Renminbi and its Acceptance as a SDR Currency

ITO Hiroyuki
Visiting Fellow, RIETI

Renminbi has been selected to become one of the SDR basket currencies

In November 2015, the International Monetary Fund (IMF) decided to include the Chinese currency renminbi (RMB) in the basket of currencies that make up the IMF's special drawing rights (SDR). In principle, this decision implies that the RMB has been recognized as one of the key international currencies. More precisely, the RMB has been selected to join four other incumbent currencies--the U.S. dollar, euro, Japanese yen, and UK pound--to constitute the basket for the SDR, which is a virtual currency the IMF uses to provide emergency rescue funds for crisis economies. A country that requests IMF assistance will first receive an emergency loan in the SDR and then use the loan by converting the SDR into the constituent currencies of the SDR basket. Therefore, the fact that the RMB will be one of the currencies in the SDR basket from 2016 on means that it will have become "officially" recognized as one of the major international currencies.

Some may think that the IMF's decision is a natural outcome of the fact that the Chinese economy is the second largest in the world. However, it does not mean it is uncontroversial. The IMF sets the following two requirements for joining the SDR: the country has to be one of the largest exporters in the world, and its currency must be freely useable in the market. Given that China is the world's largest trading country, the first requirement is obviously met. However, the question of whether the RMB is a "freely usable in the market" is questionable. In fact, many observers argue the answer is "No." If so, what would be the problems if an SDR currency is not freely usable in the international financial markets?

As previously noted, a country that receives an emergency loan needs to convert the SDR into the constituent currencies. The shares of the currencies that have been decided upon to be included in the SDR basket for the 2016-20 period are: 41.73% (41.9% as of 2011-2015) for the U.S. dollar, 30.93% (37.4%) for the euro, 8.33% (9.4%) for the yen, 8.09% (11.3%) for the pound sterling, and now 10.92% for the RMB. Hence, hypothetically, if the RMB were completely inconvertible outside China due to regulatory controls imposed by the Chinese government, that would have to mean that the country that received the emergency loan could not use about 11% of the loan. In reality, however, the RMB has been becoming more convertible to other currencies, though the RMB transactions outside mainland China and Hong Kong have yet to reach the level at which it can be used completely freely. Outside of China, major financial markets such as London and Singapore have started allowing for RMB transactions, and this trend is spreading to other markets. However, the degree of freedom of the RMB for cross-border transactions falls short of the level of existing international currencies such as the U.S. dollar, euro, yen, and pound sterling. Many researchers think that it would even take 20 to 30 years for the RMB to become as convertible and convenient as the yen (that is the least international among the incumbent four major currencies).

In recent months, with both the Chinese economy and its financial markets starting to look bleak, Chinese government authorities have frequently intervened in the financial markets explicitly and implicitly through attempts to manipulate the prices of financial assets, such as exchange rates and stocks. At this point, Chinese monetary authorities appear far from willing to completely lift regulations on financial investments both inside and outside China. Given these circumstances, it is still uncertain how far liberalization will progress as well as how widely enough it will be used in the global markets for the RMB to be recognized as an international currency.

Why does China insist on making the RMB an SDR currency?

Why does China insist on making the RMB "officially" recognized as an international currency under the IMF system? One obvious reason is the country's desire to become recognized as an economic superpower. However, there is a more practical reason. Instead of residing in the sphere of the dollar block and being subject to U.S. monetary policy, China has wanted to break away from the dollar-centric system and build its own sphere of influence, more specifically, a China-centered economic sphere with the RMB as the key currency. Circumstantial evidence for this inclination includes the country's strong initiatives to establish the Asian Infrastructure Investment Bank (AIIB) and the New Development, or "BRICS," Bank. These efforts are quite understandable given the rapid rise of China's economic size and might.

The second reason is that the Beijing government appears to aim to use the inclusion of the RMB in the SDR basket as a leverage to further push economic reforms in China, just as the country did with its entry to the World Trade Organization (WTO) in 2001. In the mid-1990s, China made significant progress in fundamental economic reforms such as large-scale privatization and the downsizing and consolidation of state-owned enterprises (SOEs). However, by the end of the 1990s, these reforms began to stall since the government faced strong oppositions from SOEs as well as government bureaucrats and Communist Party members who supervised SOEs or anyone with vested interests. In such a situation, the efforts to become a WTO member turned out to be a good excuse for the government to push liberalization and marketization of the economy and eliminate inefficient SOEs and people with vested interests. In retrospect, the entry to the WTO allowed China to further progress with liberalization because the accession required the country to further liberalize markets and introduce international standards.

By making the RMB into one of the SDR basket currencies, Chinese authorities will be able to send a message to the international community that China is fully committed to the liberalization of the financial market, and use external pressure as leverage against the state-owned financial institutions that have been trying to cling on to vested interests and prevent further liberalization. Furthermore, the authorities will be able to blame the west, especially the United States, as a scapegoat if any problem or policy failure arises.

Looking to the future of the RMB

Will financial liberalization really lead the RMB to becoming a currency comparable with, or even surpassing, existing major international currencies such as the U.S. dollar and the euro? Or will it end up like the yen, which failed to become a major international currency despite Japan's efforts to promote the currency and implement financial liberalization? These two questions warrant examination.

While we cannot predict the future of the RMB, we can draw lessons from the past experiences of the major currencies. In a joint study with University of Tokyo Professor Masahiro Kawai, I analyzed trends in the use of the U.S. dollar, yen, and deutsche mark as trade invoicing currencies from the 1970s to the 1990s and examined the determinants of these trends. Currency invoicing in trade is an important first step for any national currency to become an international currency. The fact that China first liberalized the use of the RMB for trade settlements in 2009 around the time when it began promoting RMB internationalization indicates how much the internationalization of a currency is influenced by the role it plays in trade invoices and settlements.

One of the major results we obtained from this study is that the extent to which a country belongs to a major currency zone such as the U.S. dollar, yen, and deutsche mark--which is known as the "weight in the currency basket" in economic jargon, or more plainly, the extent to which a country attempts to stabilize its currency against one of the major currencies--is found to be one of the major factors that affects a country's decision to use a currency for trade invoicing. In other words, the tendency to invoice trade transactions in U.S. dollars (mark) becomes stronger in the countries that belong to the dollar (mark) block. The larger trade volume a country has with countries that belong to the dollar (mark) zone, the more likely it is invoice its trade in dollars (mark). These results suggest that the reason why the deutsche mark was firmly established as a regional key currency in Europe before the introduction of the euro in 1999 is that many European countries belonged primarily to the mark zone, and they actively conducted trade among themselves using the mark as the main invoicing currency. In contrast, because most of Japan's neighboring countries belong to the dollar zone, it was, and still is, difficult for the yen to be more widely used as a trade invoicing currency. Even as of now, the share of Japan's exports invoiced in the yen is less than 40%, while that of exports in U.S. dollars is more than 50%. In imports, these shares are 20% and 75%, respectively. Compared to other developed countries, the percentage of trade invoices in its own currency is substantially low for Japan while its high dependency on the U.S. dollar is notably high. Outside Japan, the share of the yen is even lower. We also found that among the issuing countries of the major currencies, countries with developed and open financial markets are more likely to use their own currencies for trade invoices. Thus, both financial development and liberalization is important for a country to internationalize the use of its own currency.

These results provide important implications for the issue of RMB internationalization. In the sense that the income level of China will continue to rise in the future, and that the country will continue to be a major trading country, the RMB is expected to make progress toward further internationalization. However, at the same time, it is uncertain whether financial liberalization and deregulation will advance smoothly, considering that Chinese financial authorities lately have been excessively intervening in financial markets and manipulating the exchange rate as mentioned earlier. More importantly, just like Japan, China is surrounded by countries that belong to the dollar block. This will pose a quite difficult challenge for the RMB. The key factor is how much China's neighboring countries in Asia will start using the RMB for international trade and financial activities, breaking away from the dollar block. It is no exaggeration to say that the RMB and the U.S. dollar will clash over global economic hegemony in Asia as the main battlefield.

January 19, 2016

January 19, 2016