Lee Jong-Wha writes: By the end of this year, the International Monetary Fund will decide whether the Chinese renminbi will join the euro, the Japanese yen, the British pound, and the US dollar in the basket of currencies that determines the value of its international reserve asset, the Special Drawing Right (SDR).
The IMF created the SDR in 1969 to supplement existing reserve currencies, thereby providing the global financial system with additional liquidity.
To qualify for inclusion, the Chinese government has eased its capital controls and liberalized its financial markets considerably. Yet the US, in particular, reluctant to welcome China into the fold.
This is all the more problematic given that the 2008 financial crisis laid bare the international reserve system’s inadequacy when it comes to ensuring sufficient liquidity for emerging economies.
This continued vulnerability reflects a collective failure to reform the global monetary system. China has championed a transition to a multi-currency reserve system, in which the SDR and an internationalized renminbi would be used more widely, including in countries’ currency reserves. But its attempt in 2010 to add its currency to the SDR basket failed, because the renminbi was not “freely usable.”
Since then, China has implemented a series of reforms to increase the renminbi’s usage in foreign trade and direct investment, as well as in cross-border financial investment. Fourteen renminbi-clearing banks have been established worldwide
Chinese policymakers have signaled further financial liberalization by removing the domestic cap on banks’ deposit rates, thereby giving overseas institutional investors easier access to capital markets. The PBOC is also likely to widen the currency’s trading band and move toward a more flexible exchange-rate regime.
As a result of these efforts, the renminbi has emerged as the second most used currency in trade finance.
Of course, China stands to gain much from the renminbi’s emergence as an alternative international reserve currency.
But China must confront significant risks. Capital-account liberalization and renminbi internationalization invite potentially volatile cross-border capital flows, which could, for example, trigger rapid currency appreciation.
Even if China manages to mitigate such risks, unseating the US dollar as the dominant global currency will be no easy feat. Inertia favors currencies that are already in use internationally, and China lacks deep and liquid financial markets, an important precondition that any international reserve currency must meet.
If, however, China succeeds in developing a more convertible capital account and bolstering its financial system’s efficiency, the renminbi is likely to emerge as a new international reserve currency, complementing the US dollar and the euro.
For now, China is focused on winning the renminbi’s inclusion, even with a small share, in the SDR currency basket. The IMF’s major shareholders should seriously consider it. The renminbi’s continued internationalization, not to mention further progress on critical financial reforms, would contribute to the creation of a more stable and efficient global reserve system.
