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Financial shift with geopolitical implications

Financial shift with geopolitical implications

Small step for money, giant leap for monetary system

by David Marsh

Mon 30 Nov 2015

The renminbi’s entry into the special drawing right represents the first time that a currency of a developing country becomes a de jure reserve asset – official recognition of a momentous shift in the global power balance. The SDR is the International Monetary Fund’s artificial composite currency unit, part of the glue that binds world finance, but with no real role on international markets. This is a small step for money – but a giant leap for the monetary system.

The IMF’s ruling, backed today by its executive board in Washington, that the renminbi is ‘freely usable’ and thus can be included in the SDR from next October – despite the persistence of some Chinese capital controls – has geopolitical implications. Acquiescence by the US in this landmark move is recognition that China’s march to the top table of the world economy is unstoppable. Yet confirmation of a multicurrency reserve system – under which the Chinese currency joins the dollar, euro, yen and sterling as a reserve asset — could herald considerable fragility as the world monetary system moves in the next few years to a new modus operandi.

The vote by the IMF board to make the renminbi the fifth currency in the SDR basket follows a relatively short, well-orchestrated campaign by the Chinse authorities to promote recognition. The renminbi will become the third biggest currency in the SDR basket from 1 October. Christine Lagarde, IMF managing director, called it a major milestone in China’s economic reform journey.

The inclusion of the Chinese currency marks the most significant change in the IMF’s basket since the euro replaced the D-mark and the French Franc in 1999. The dollar will remain the biggest currency with a 41.7% weighting followed by the euro with 30.9%. With a 10.9% share, the renminbi moves beyond the yen (8.3%) and sterling (8.1%).

The move has limited significance for the use of the SDR on private markets. For the SDR to gain momentum in borrowing and investment, it would need to become a currency in its own right, similar to the development of the European currency unit, used in the bond markets from the late 1970s onwards. The Ecu’s bond deployment accelerated in the 1990s as the countdown to its transformation into the euro got under way. An analogous change for the SDR looks unlikely.

A more likely bond market beneficiary of a wider SDR is be the renminbi itself. In the short run, the decision may prompt a further $100bn worth of official buying of renminbi-denominated assets. Longer term, the figure could be much greater — raising the question of how supply of good-quality renminbi assets could be increased to meet this extra demand.

By contrast to the artificial SDR, the renminbi is becoming much more real for investors around the world. Approval of renminbi inclusion is of enormous symbolic value to Beijing, reinforcing its bid to turn the renminbi into an international hard currency and to challenge western dominance of global monetary governance. More specifically, it could trigger a large shift of global institutional assets into renminbi.

Already, the renminbi has become de facto a reserve currency. On rough calculations, there may be about $100bn of renminbi reserves in central bank holdings, about half the total held in Canadian and Australian dollars, according to IMF estimates. On this basis, SDR inclusion could spark a further $100bn worth of renminbi purchases by central banks.

This is not a huge figure compared with OMFIF’s estimate of global official sector assets of $30tn, and daily foreign exchange turnover estimated by the Bank for International Settlements at $5.3tn. But shifts of this nature could be a milestone event, especially if similar movements follow in the private sector.

The overall renminbi bond market, including both public and private sector debt, is estimated at about Rmb35.9tn, according to Goldman Sachs, the third largest in the world after the US and Japan. There may be a shortage of renminbi-denominated investable assets for world central banks in coming years. Chinese government borrowers are unlikely to generate significant additional issuance in coming years. So part of the demand from worldwide central banks may have to come from renminbi issuance by top-rated agencies such as the World Bank and sovereign governments, where the British government gave a lead last year with a Rmb3bn issue. One important implication of the SDR move is that there will be more such bonds from western governments in coming years.

David Marsh is managing director of OMFIF.

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