The renminbi - in the top league, but not yet in the Champions League
Despite being part of the IMF basket of currencies – which is the most difficult obstacle on the road to becoming a true international reserve currency – the renminbi is not yet on an equal footing with the US dollar or the euro. By Michael Menhart, Chief Economist at Munich Re.
At last, we have some positive news about China. On Monday, the International Monetary Fund (IMF) decided to include the Chinese renminbi in its basket of currencies as from 1 October 2016. This step symbolises the shift of power in the global economy. It is an important and prestigious triumph for China, as its currency will now be playing in the same IMF league as the US dollar, the euro, the British pound and the Japanese yen. But China is still a long way from being a contender in the Champions League.
The IMF's decision sends an important political signal. The emerging economies have long complained about their disproportionately low level of influence at the IMF. The more China's importance for the global economy has grown, the more US dominance at the IMF has become a thorn in Beijing's eye. Although a proposal to change voting rights at the IMF was rejected due to objections from the US Congress, at least China has now been given the recognition of being added to the list of currencies which make up the IMF's Special Drawing Right (SDR). But the inclusion does not mean a lot. And despite being part of the IMF basket of currencies – which is the most difficult obstacle on the road to becoming a true international reserve currency – the renminbi is not yet on an equal footing with the US dollar or the euro. More than 60% of global reserves are still held in US dollars. China's share of world trade is currently 13%, but only 3% is transacted in the renminbi.
Four substantial criteria for a reserve currency
Historically, a country's economic dominance has also gone hand in hand with an increasing global presence of its currency. That is what happened with the US dollar after the Second World War, and with the deutschmark and Japanese yen in the 1970s. The size of the Chinese economy indicates that the renminbi is likely to become even more important. China is the world's second-largest economy, and has been the world's third-largest exporter after the USA and the eurozone since 2009. The question of whether a currency is recognised as a reserve currency depends not only on a country's economic importance and trading strength, but also on trust in its currency and the stability and transparency of its financial markets. But does China really fulfil the criterion of a sufficiently freely convertible currency? The IMF decision puts this in a favourable light.
The IMF's reasons in favour of inclusion of the renminbi were linked in part to the successes achieved in reforming Chinese financial markets. In fact, there has been some progress here. More and more countries are now able to settle their trades directly in the renminbi because of a swap agreement with China. The Chinese interbank market is opening itself gradually to foreign institutions. State intervention in the management of exchange rates does not present an obstacle to inclusion in the IMF basket of currencies. Nevertheless, the government in Beijing will have to take a back seat in this respect if it is serious about its reform course. It sees the strong devaluation of the renminbi this August as clear evidence that market forces are increasingly determining the level of the Chinese currency. But the exchange rates for the renminbi are still set each day by a government office.
The August devaluation may have appeared surprisingly strong as far as most market players were concerned. But one can absolutely debate about whether the government side really bowed to market forces or whether – at least in part – the economic planners wanted to have a weaker currency because of slower growth and disappointing export figures. China's commitment to more market and less state intervention will become really credible only when it permits painful consequences for its own economy and the degree of planning realisation. This is where Beijing is faced with a dilemma. The more the Chinese government opens up its financial markets, the more strongly market players will feel the effects of crises and upheavals. There is already substantial potential for this in China – from the highly indebted corporate sector, through doubts about the sustainability of municipal finances, to the danger of a collapse in the real estate market.
How serious is Beijing about opening its markets and its reforming zeal?
Over the past 20 years, the world's trust in the stability of the Chinese economy was, above all, based on trust in the ability of Chinese state leadership to control the dynamic development in China by means of state intervention without triggering massive upheavals. This is remarkable enough, as virtually no politician in the Western industrial world would be entrusted with such a task. But this will no longer be sufficient for China to rise further and for the renminbi to be established as a reserve currency. The financial markets will now look very closely at whether Beijing is serious about opening its markets and its reforming zeal once things begin to get more complicated and setbacks are more perceptible. China could still use its enormous currency reserves to put out a few fires in its financial markets. Almost no one doubts that.
But the Chinese leadership will have to earn the trust of the markets that it will no longer do this so frequently, and that it is prepared to allow crises to happen and to live with the consequences. Previous reform measures in this regard have not gone far enough, particularly in the private sector. Capital outflows from China are still subject to heavy restrictions, but some restrictions have been eased with respect to capital inflows. The reform process will require not only courage, but also a great deal of time. The IMF is hoping that adding the renminbi to its basket of reserve currencies will strengthen China's path of reform. Only when this succeeds will China be promoted to the Champions League of global financial markets and manage to hold its own at that level. It remains to be seen whether China will be able to pull this off.