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Analysis
China’s long march on SDR, renminbi

China’s long march on SDR, renminbi

Beijing dollar rivalry may face setbacks 

by David Marsh

Wed 24 Aug 2016

The World Bank’s forthcoming launch of $2.8bn worth of bonds denominated in special drawing rights on the Chinese market is a further landmark step in China’s long march to support the International Monetary Fund’s accounting unit as a potential rival to the dollar.

The World Bank’s programme of SDR bonds, payable in renminbi, is expected to be accompanied by similar issues for the China Development Bank and other Chinese banks.

The relaunching of SDR-denominated bonds after a three-decade absence is linked to the renminbi’s entry into the SDR on 1 October, where it will join the dollar, euro, yen and sterling as an acknowledged reserve currency. This could open the way for central banks and other official institutions to boost SDR- and renminbi-denominated investments.

Subscription in renminbi for the SDR bonds is part of an effort by the Chinese authorities, prefigured in talks with the IMF at the Fund’s spring meetings in Washington in April, to allow domestic Chinese investors to participate in bond issues with a significant foreign currency component.

This will help not only to boost development of the Chinese bond market, but also to damp capital outflows that have gained ground in the last two years as a result of liberalisation of capital controls. Chinese foreign exchange reserves have steadied at around $3.2tn since February after earlier falling sharply from $4tn in mid-2014. This stabilisation has matched general developments among emerging market economies, where foreign exchange reserves have starting to rise again after an 18-month slide – the subject of OMFIF reports in June 2016 and September 2015.

In a research paper in July, the IMF pointed to Chinese investors’ untapped demand for exposure to reserve currencies. ‘From this perspective, market-based SDRs issued in the onshore market could potentially reduce demand for foreign currency and reduce capital outflows by allowing domestic market participants to diversify their foreign exchange risk.’

The People’s Bank of China has imbued the move with unusual significance. It stated on its website that the reopening of the SDR market will ‘enhance the stability and resilience of the international monetary system, [since] bonds denominated in the SDR will provide a hedge against the interest rate and exchange rate risks stemming from financial instruments denominated in a single currency’.

However, no one should think that these Chinese and IMF initiatives add up to a major impending threat to the dollar.

History is littered with such episodes. The most spectacular was the planned IMF SDR ‘substitution account’ in 1979-80, which led to a major dollar revival – where projects aimed at dismantling the dollar’s primary role ended up strengthening it.

Disruptive geopolitical occurrences (and the possible election of Donald Trump on 8 November might be one) tend to underpin rather than undermine the dollar’s status.

As Paul Tucker, former deputy governor of the Bank of England, pointed out earlier this year, the dollar’s celebrated ‘exorbitant privilege’ extends beyond ‘geopolitical returns and reduced funding costs’, since it also provides ‘an economic shock absorber and, therefore, domestic political insurance’.

Applied to the Chinese case, if the renminbi were ever to become a fully-fledged world currency backed by deep, extensive and reliable Chinese financial markets, any upsurge in geopolitical tensions in Asia, for example over Chinese territorial claims, could spark a rise in the renminbi – a welcome ‘geopolitical hedge’ for the Chinese leadership.

Equally, however, accomplishing this longer-term role faces grave setbacks if fragility emerges in China’s political and economic system, for example over the Chinese growth slowdown accompanied by capital control liberalisation and increased foreign influence on the Chinese economy.

These factors explain why the aim of emulating the dollar is high on the agenda of top Chinese government officials – and simultaneously why they know that achieving it is extraordinarily difficult.

David Marsh is Managing Director of OMFIF.

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