The implications of RMB inclusion within the SDR

On October 1, 2016, China’s currency will join the US Dollar, Euro, Japanese Yen and British Pound in a unique and highly selective unit of account—the International Monetary Fund’s Special Drawing Right, or SDR. The Renminbi’s inclusion in the SDR follows a concerted, multi-year lobbying effort by Chinese authorities along with challenging deliberations by the IMF’s Executive Board. It marks a major milestone in China’s ascension in the global financial system, and sets the RMB on a path to becoming a major reserve currency, widely owned by other central banks as part of their foreign exchange arsenals.

But is membership in this elite currency club cause for unbridled celebration? Upon deeper reflection, RMB inclusion within the SDR is almost certain to subject China to greater policy demands and economic challenges. It also exposes the IMF to possible claims of political favoritism: to admit the RMB in the SDR, the IMF had to stretch its own criterion of “free convertibility.” At a time when the global economy needs greater integration, coordination and co-operation, IMF legitimacy is not an asset to be squandered.

Of the risks for Chinese policy makers, the challenge of large, unwanted capital inflows/ outflows during times of pronounced uncertainty is perhaps the most pernicious. Of the five currencies set to comprise the SDR, the RMB is the most heavily managed, by far. Indeed, from July 2014 to March 2016, China’s foreign exchange reserves fell by 20 percent, or nearly $1 trillion, as the central bank intervened heavily to limit the RMB’s devaluation. No central bank can set the value of its own currency without capital controls when global markets move unilaterally against them. Regrettably, central bank reserve managers are highly prone to pro-cyclical investing: that is to say, they are more likely to sell assets in a time of crisis than buy them, as witnessed by European peripheral debt spreads during the Euro crisis and US government agency debt during the sub-prime crisis.

If, as should be expected, the RMB becomes more widely held by central banks in the future, and if, as should also be expected, China incurs some unwelcome political or economic events in the future —akin to, say, Great Britain’s Brexit decision—more RMB may be sold in the markets than Chinese authorities could practically manage. An unruly devaluation of the RMB would almost certainly force China to impose capital controls, effectively ending its “free convertibility” status. In such circumstances, RMB inclusion in the SDR would end ignominiously, and with truly debilitating impact across global markets.

Of equal concern, Chinese authorities are now likely to be exposed to the famous Triffin dilemma or paradox. More than a half-century ago, Belgian-American economist Robert Triffin observed that demand for reserve currencies all but axiomatically reverberates on a county’s current account, promoting trade deficits in place of trade surpluses. This is because surpluses and deficits on current and capital accounts ultimately must sum to zero. Self-evidently, China’s historic growth model has been heavily dependent on trade surpluses. Until domestic demand rises to meet China’s immense supply capacity, continued trade surpluses seem necessary to avoid large increases in unemployment and outright recession. RMB inclusion in the SDR effectively increases the urgency of further migrating Chinese economic policy from export-led growth, to deeper sources of domestic demand.

For the IMF’s part, nothing would be more welcome than to have China as a fully contributing, responsible global stakeholder. Our global financial architecture was created in the aftermath of World War II, at a conference in Bretton Woods that representatives from the People’s Republic of China did not attend (Taiwan, or the Republic of China, did participate, however). No global organization today can speak with full authority and legitimacy while ignoring the world’s most populous state and second largest economy. This said, a rules-based global order is man’s best hope – and some rules, like full convertibility, are simply too important to be ignored.

The RMB’s inclusion in the SDR will integrate China more fully into the global financial architecture, creating opportunities for China to assert itself more forcefully in G-20 discussions about global growth, stability and sustainability. But every privilege entails some responsibility. The IMF’s decision to admit the RMB into the SDR presents great opportunities for China and the global financial system. But life for Chinese policymakers will not become any easier because of it. China’s domestic challenges—like those in the US, Europe and Japan—will now take on new, international dimensions.

Julian Keeley is a Trinity senior. His column, “individuals and institutions,” runs on alternate Fridays.