Wanda Tseng: RMB to be Included in the SDR Basket by 2020

2015-12-01 IMI

Wanda Tseng, Former Deputy Director in the Asia and Pacific Department of IMF. International experience points to several factors that are important in a currency’s internationalization and its successful rise as a reserve currency. These factors include: economic size and wide trade networks that generate demand for a currency as a unit of account and medium of exchange; macroeconomic stability and a commitment to low inflation and a sustainable public debt that enhance a currency’s credibility and attractiveness as a store of value; capital account convertibility that allow a currency to be easily tradable in global financial markets; depth and liquidity of domestic financial markets (together with currency convertibility) that allow global investors access to a wide range of financial instruments denominated in the home currency that can be used for investment and as a stores of value. China has certainly met the condition of economic size and centrality to global trade. With rapid growth over 35 years, China became the world’s second largest economy in 2010; it now accounts for about 15 percent of global output, up from 2 percent in 1980. Even with an expected moderation of growth in the future as China seeks to rebalance its economy, both the IMF and the World Bank forecast that China are likely to overtake the U.S. as the world’s largest economy by 2030. Furthermore, China’s growing economic size has been accompanied by a significant rise in its importance in global trade. China became the world’s largest merchandise exporter in 2008, and the world’s largest merchandise importer in 2013. It now accounts for over 10 percent of global trade, up from a mere 3 percent in 2000. It is well networked with other economies through trade linkages and its role as the center of the global supply chain for manufacturers. As for macroeconomic stability, China has achieved high rates of economic growth with relatively low rates of inflation, especially in recent years. China’s government budget deficit and public debt, even considering local government debt, are modest compared to those in the major reserve currency economies. China’s exceptional and consistent economic performance over a long period, together with China’s holding of nearly US$4 trillion in international reserves, should have earned the renminbi (RMB) an increasing degree of credibility in global financial markets. According to international credit rating agencies, China’s credit rating is investment grade and the rating outlook is stable. The RMB is not convertible on the capital account; major controls remain in place, mainly on FDI, residents’ external borrowing, and nonresidents’ investment in domestic financial markets. Nevertheless, China has gradually and cautiously relaxed capital controls, notably in allowing increasing amounts of capital inflows (within specified quotas) under the Qualified Foreign Institutional Investors program (QFII) and capital outflows under the Qualified Domestic Institutional Investors program (QDII). As a result, gross inflows have risen sharply over the past decade, reflecting China’s attractiveness as a destination for foreign investment. Outflows, including investments abroad by Chinese corporations and institutional investors, have also grown substantially. While China’s capital account is becoming increasingly open, various measures of capital account openness show that China’s capital account remains much less open, not only compared with the reserve currency economies such as the euro area or the United States, but with many emerging economies as well. Financial market sophistication is important for a currency’s international status, as the currency must be usable not only in international trade but also for investment. To be attractive to global investors, a country’s financial market must offer a broad range of financial instruments (breadth), a large volume of financial instruments in each market (depth), and a high volume of transactions (liquidity). These characteristics provide an adequate supply of financial instruments for global investors. As a proxy for financial depth, an IMF study looks at the share of a country‘s contribution to the stock of securities according to: the MSCI World Index, international debt outstanding, and domestic debt outstanding. By these measures, the shares of China in global capital markets, while increasing, remain minuscule. While progress has been made with financial sector reforms over the past decade, China’s financial system still has considerable distance to go before reaching the breadth, depth, and liquidity of those in the reserve currency countries. China’s financial sector is dominated by the banking system, still largely owned and controlled by the government. Total domestic bank credit is larger than the combined bond and equity market. China’s debt securities market has grown rapidly in recent years, but it still lag far behind those of major reserve currency economies in size and liquidity. The government debt market is large in absolute terms but the volume of transactions is low as the majority of bonds are held to maturity by domestic investors. China’s corporate bond market has grown rapidly in recent years and turnover is high, but its size is still small. The equity market in China has grown rapidly in recent years. Since reforms in 2005, market capitalization, turnover, and trading volume have all surged, but there are concerns about corporate governance and the regulatory framework. Financial derivatives markets are still nascent, hindering the hedging of risks, which is important for global investors. On the question of whether the RMB can become one of three major international currencies by 2020, it is useful to look the IMF’s criteria for “freely usable” global currencies. At present, the IMF considers only four currencies as being widely used and widely traded international currencies: U.S. dollar, euro, Japanese yen, and the British pound; these four currencies constitute the currency basket for the IMF’s Special Drawing Rights (SDR). Several indicators as used to assess whether a currency is widely used globally and widely traded on principal foreign exchange markets. These indicators include: currency composition of official reserve holdings: While an increasing number of central banks around the world reportedly has added RMB to their foreign exchange reserve holdings, data on use of the RMB in global foreign exchange reserves are not available. Nevertheless, the share of RMB in global reserves is likely to be tiny. According to the most recent IMF data, the share of reserves denominated in “other currencies,” which includes the RMB, in total “allocated reserves ” is about 3 percent at end-Q3, 2013; the U.S. dollar remains dominant at 61 percent, followed by the euro at 24 percent, and the Japanese yen and British pound at 4 percent each. Available data indicate that while the share of “other currencies” has risen in recent years as central banks moved to diversify their foreign currency holdings, the extent of diversification has been very limited. A supplemental indicator of RMB use as a reserve currency is the number of central banks holding the currency. A survey of reserve managers shows that the RMB was held by 15 percent of the respondents (RBS, 2013). While the RMB appealed to some reserve managers, its lack of convertibility was often cited as an obstacle to investment. Within the next five to ten years, however, 37 percent of the respondents indicated that they would consider investing in the RMB. currency denomination of international banking liabilities and international debt securities: BIS data on amounts outstanding of international liabilities show the continued dominance of the U.S. dollar and the euro in international financial transactions. The share of each of these two currencies has remained broadly stable with a combined share in the 75 to 80 percent range. The Japanese yen and the British pound follow far behind in the third and fourth ranking. The share of the RMB is not separately reported, but included in “other currencies” which accounted for 7 percent at end September 2013. volume of transactions in foreign exchange markets: According to the Bank for International Settlements’ Triennial Central Bank Survey, the RMB became the ninth most actively traded currency in 2013. The Survey noted that the role of the RMB in global FX trading surged, mostly driven by a significant expansion of offshore RMB trading. RMB turnover soared from $34 billion in 2010 to $120 billion in 2013. Nevertheless, RMB’s share in global FX volume was 2.2 percent, compared with 87 percent for the U.S. dollar, 33 percent for the euro, 23 percent for the Japanese yen, and 12 percent for the British pound. In sum, some of the fundamental drivers for internationalization of the RMB are in place, based on China’s economic size, growth potential, and trade linkages. However, modernizing and deepening the financial sector and gradually opening the capital account are still works in progress. While the RMB has gained ground as a currency for trade settlement, it still has some way to go to achieve the “widely used” and “widely traded” criteria in global financial transactions for an international currency. I believe there is great potential for the RMB to become an international currency. For RMB internationalization to advance, the main challenges ahead are liberalizing the capital account, supported by financial market liberalization to develop deep and liquid financial markets and liberalize interest rates and exchange rates, and strengthening the supervisory and regulatory framework. The pace and sequencing of these reforms is also a challenge, given the recent experience with financial crisis in countries that opened their capital account with less developed financial markets and weak supervisory frameworks. These reforms have long been at the core of China’s reform agenda and the Third Plenum announced plans to accelerate reforms. If these reforms can be carried out successfully, I see no reason why the RMB cannot become a “freely usable international currency” as defined by the IMF for inclusion in the SDR basket by 2020.

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Wanda Tseng: RMB to be Included in the SDR Basket by 2020

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