The IMF's Addition of China Is Largely a Symbolic Gesture

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On Monday the International Monetary Fund (IMF) announced it was adding the Chinese renminbi to its basket of reserve currencies, joining four other elite global currencies-the U.S. dollar, the Euro, the British pound and the Japanese Yen-that determine the value of Special Drawing Rights, the IMF's own currency.

Some hailed it as a watershed moment. IMF Managing Director Christine Lagarde called it "an important milestone in the integration of the Chinese economy into the global financial system." But, for now at least, the action is largely just symbolic.

Once considered an exotic currency, the renminbi has gained traction in recent years thanks to China's emergence as a global economic powerhouse. China now ranks as the world's largest exporter (accounting for 14 percent of global exports, up from just 6 percent a decade ago) and its second largest importer.

Currently, China settles 25 percent its trade accounts with the renminbi, and Beijing is gradually opening its capital account to overseas investors. The Financial Times reports that, at the end of the first quarter of 2015, foreigners owned RMB4.2 trillion ($680 billion) in Chinese bonds, equities, deposits and loans. And this year the renminbi surpassed the Yen as the world's fourth most used payment currency.

The IMF's inclusion of the renminbi may automatically increase demand for the Chinese currency, because many central banks use the Special Drawing Rights as a benchmark in allocating their foreign exchange reserves.

And three ventures recently founded and led by Beijing-the New Development Bank (NDB), the Asian Infrastructure Investment Bank (AIIB), and the "One Belt, One Road" initiative-could, if successful, also boost demand for the renminbi.

But one should not make too much of the renminbi's promotion at IMF. The fact is Special Drawing Rights are largely an anachronism. While IMF bailouts are officially denominated in their own currency, the reality is that the actual bailout money is settled in dollars, euros or the local currency of the borrower.

And despite the aforementioned progress of the renminbi, it still is not a fully convertible currency-a necessary condition the IMF seems to have ignored. Moreover, its use globally remains minuscule. According to the Financial Times, just 38 of the 188 IMF member countries held any of their foreign exchange reserves in renminbi in 2014, and those holdings represented only 1.1 percent of total global reserves and only 1.4 percent of international debt securities.

Indeed, the most significant element of the IMF's embrace of the renminbi is that it will place enormous pressure on Beijing to fundamentally change seven decades of secrecy. The People's Bank of China would be expected to have a level of transparency closer to that of the European Central Bank and Federal Reserve. The exchange rate would have to exhibit greater flexibility, and interest rates on deposits and loans would have to be liberalized.

Currently, deposit and lending rates are set by the state. Interest rates set by the market would reflect economic realities, decreasing the probability of future insolvencies in the banking system and reducing capital flight out of renminbi-denominated assets.

Currently, China's domestic financial market is at a rudimentary stage of development, and the capital account is tightly controlled, restricting the free circulation of renminbi across borders. The renminbi cannot become a full-fledged reserve currency until capital controls are completely lifted. But for that to happen domestic markets must be deepened and banks placed on a purely commercial footing. Otherwise, large capital flows could upset monetary policy or systemic stability.

Ultimately, the renminbi's greatest obstacle is political. The Chinese Communist Party can change rules and expropriate assets on a whim. The absence of rule of law in China does not exactly reassure investors. Until now, all reserve currencies in history were from democratic countries.

Unfortunately, there is already evidence that Beijing's leaders are backsliding on reforms. They've abandoned the goal of freer financial markets by the end of 2015, pushing the deadline for needed reforms off until the end of this decade. And last summer they aggressively intervened in the collapsing stock market, preventing investors from selling their share prices. These are hardly policies that engender confidence, and in turn, demand for the renminbi.

Given all these obstacles and an almost nonexistence presence in central bank foreign exchange reserves, why did the IMF include the renminbi in its market basket? There are two primary reasons.

First, size matters. In terms of purchasing power parity, China surpassed the U.S. in 2014 and is now the largest trading partner for 75 countries.

Second, despite recent setbacks, there is increasing confidence that China will continue to slowly liberalize its financial markets. That would certainly increase global demand for RMB denominated assets. But whether or not it comes to pass remains to be seen.


A former Chief Economist for Ernst & Young, William T. Wilson is a senior research fellow in the Heritage Foundation's Asian Studies Center. 

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