Yuan's SDR inclusion signals change in international financial system
The International Monetary Fund's executive board decided in late November to add the yuan to the basket of currencies that make up the Special Drawing Rights. The yuan will become the fifth currency in the basket after the dollar, euro, yen and British pound when it joins them in October 2016.
The decision means that the IMF members recognize that the yuan is a freely usable currency, as stipulated in the organization's Articles of Agreement. They have also given positive evaluations to China's increasing presence in the global economy and efforts by the country's authorities to liberalize and internationalize its domestic financial market.
However, given the SDR's very limited role as a reserve asset, the yuan's inclusion in the basket is largely symbolic and unlikely to have a direct and significant impact on the currency's internationalization. China needs to ensure stability and transparency in its macroeconomic management and liberalize its financial markets and capital transactions further to enable the yuan to be used as a genuine reserve asset. The IMF decision is expected to help facilitate these moves.
Meanwhile, the yuan's addition to the basket that has been made up only with currencies of advanced economies shows that the international financial system led by rich Western countries is changing. The slow progress in IMF governance reforms seems to create an even bigger gap with the transforming global economy.
There are two requirements for a currency to be a component of the SDR. Firstly, the country's export value of goods and services must be very large; and secondly, the IMF recognizes the currency as freely usable. For the yuan, the first was obvious, but the second needed judgment.
"Freely usable currency" is a notion in the IMF Articles of Agreement. They need to be recognized by the IMF as being widely used for payment of international transactions and traded on major foreign exchange markets. When member countries take out loans from the IMF, they receive the money in freely usable currencies. The notion only means the currencies received can be widely used for international settlements. It does not call for floating exchange rates or complete convertibility with other currencies.
The IMF does not have strict criteria for defining a currency as freely usable. The executive board makes a decision based on such factors as the currency's share in foreign reserves, how often it is used on the global financial market and its transaction volume on the foreign exchange market.
When the SDR was created in 1969, 1 SDR equaled 1 dollar under the fixed exchange rate. After the world's major currencies adopted floating exchange rates, the IMF introduced a currency basket for the SDR. Starting in 1974, the SDR was made up of 16 currencies, each of which accounted for 1% or more of the global export value. In 1981, the number of currencies in the basket was reduced to five (yen, dollar, German mark, British pound and French franc). The introduction of the euro cut the number to four.
The ratio of each currency in the SDR is decided based on its export value and financial indicators such as how frequently the currency is used on global financial markets. The yuan's ratio is 10.92%, the third-highest after the dollar and euro.
Discussions on a supranational currency date back to Bancor, an international reserve currency proposed by John Maynard Keynes. The IMF Agreement aims to make the SDR the principal reserve asset in the international monetary system, but the present status of the SDR is far from that.
It should be noted that the SDR is not a currency. The IMF distributes SDRs to the members, but it does not increase the organization's debt. In addition, only public authorities are allowed to possess the SDR and it is never be used for private-sector transactions. The SDR was occasionally used as a quotation for private-sector securities issuance in the early 1970s, but such usage stopped after the European Currency Unit came into existence. For regular currencies, the central banks constantly adjust the volume of issuance depending on the supply-demand balance on the market. But international liquidity management does not exist for the SDR. In addition, the SDR's accumulated distribution accounts for only around 2% of foreign reserves.
The SDR gives a country the right to request freely usable currencies from other countries in exchange for its allocated SDRs to pay for foreign payments. The IMF merely serves as an intermediary between a country in need of money and those that provide freely usable currencies (these are not necessarily the countries whose currencies are in the basket). In order to understand how the SDR acquired such a halfhearted nature, we need to look at its history.
Behind the creation of the SDR were debates over "liquidity dilemma," a theory proposed in the 1960s by Yale University professor Robert Triffin. The gold standard was in place at the time. As long as the dollar is used as the global reserve currency, international liquidity will not be supplied unless the U.S. posts a deficit in its international balance of payments. On the other hand, if the deficit continues, confidence in the dollar is lost and the fixed-rate exchange system collapses. Triffin concluded that a new reserve asset to supplement gold and the dollar was needed to ensure international liquidity as the global economy expands.
But the debates on this dilemma had become obsolete by the late 1970s, partly because major currencies shifted to floating exchange rates. Under this system, when the U.S. deficit in its international balance of payments widens, the dollar falls against other currencies as an adjustment. Another reason was rapid development of private-sector international financial markets that helped demand for international liquidity to be met to some degree without an increase in reserve assets.
The SDR's role today is to serve as a buffer for foreign reserves by providing foreign funds to low-income countries that have trouble procuring money from outside.
China has been liberalizing its financial market and internationalizing the yuan over the past several years. Making its economy more efficient and raising productivity by utilizing market functions is an important task to shift the economic focus from investment to consumption to ensure sustainable growth. Freeing up the financial market is one of the pillars of this reform. Chinese authorities have taken measures in phases to remove all restrictions on interest on deposits and expand access to foreign exchange and bond markets for overseas public authorities.
However, the liberalization process will be bumpy, as evidenced by the turmoil on the stock and currency markets this summer and nontransparent market interventions by China's authorities. Liberalizing capital transfers, especially to overseas, appears to be difficult. Reform of state-owned companies, which account for a large portion of the economy, is unlikely to progress smoothly. The yuan's addition to the SDR is a milestone for the efforts of Chinese authorities in terms of both financial liberalization and making the yuan into a genuine reserve currency. Expectations are growing that China will speed up its economic reforms.
Days before the Group of 20 summit in mid-November, IMF Managing Director Christine Lagarde issued a public statement in which she recommended to the executive board that the yuan be included in the SDR. It is unusual for such a clear message to be sent on a policy issue ahead of a board meeting. The statement was a political message that the IMF should listen to Chinese requests. But it also highlighted that the international financial system is changing while the IMF is making slow progress in its reforms aimed at giving emerging economies a larger say.
Naoyuki Shinohara is a professor at Policy Alternatives Research Institute of the University of Tokyo. He has served as Japan's vice minister of finance for international affairs and IMF deputy managing director.
This is a reproduction of the article with the same title published on NIKKEI ASIAN REVIEW on December 16th, 2015.