Why criteria matter on the SDR
by George Hoguet
China’s suggestion that the renminbi be included in the Special Drawing Right – the IMF reserve asset made up of a basket of currencies – raises important issues for China and the world.
Market participants may view it as containing some internal contradictions. Does China seek to promote greater use of the renminbi as a reserve currency, greater use of the SDR as a reserve currency and private unit of account, or both? And when?
To the extent that the renminbi is perceived not to meet the current criteria for SDR inclusion, its inclusion could lessen the already non-existent interest among market participants in the SDR as a currency of bond issuance and investment. On the other hand, to the extent that the renminbi does meet the criteria, and means are developed to provide liquidity for SDR-denominated bonds, inclusion could, over the next 25 years, enhance both the official and private use of the SDR. The point is that, for the SDR even to begin to rival the dollar as a reserve asset, a private SDR market must develop. Liquidity of SDR instruments and the SDR’s constituent currencies is vital. In this context, we need to look carefully at the criteria the IMF uses to establish SDR eligibility.
China’s SDR initiative is part of a series of measures to reduce dollar ‘hegemony’ and to promote the renminbi as a reserve currency. Full renminbi liberalisation will take a long time and is designed to facilitate the restructuring of the Chinese economy.
Over the past 18 months China’s foreign economic policy initiatives have included participation in the Brics Bank and Contingent Reserve Fund; the Asia Infrastructure Investment Bank and ‘Silk Road’ projects; and continued expansion of central bank swap lines, with facilities now established with 29 central banks. China has also added further Qualified Foreign Institutional Investor quotas and established the Hong-Kong Shanghai Connect programme. Development of the ‘Dim Sum’ bond market has continued.
In October 2015, as part of its five year review, the IMF Board will determine the constituent currencies of the SDR, which will take effect on 1 January 2016. SDRs currently account for less than 4% of global reserves. And despite a nascent SDR-denominated Certificate of Deposit market in the late 1970s (when inflation was high and the dollar was weak), the SDR as a private medium of exchange or unit of account has never taken hold. (A few airlines denominate lost baggage claims in SDRs, and some international organisations in addition to the IMF denominate their accounts in SDR.)
The Fund’s 2010 paper ‘Review of the Method of Valuation of the SDR’ outlines the broad principles and specific metrics to be used to include a currency in the SDR. These include the currency’s relative importance in the world trading and financial system; the stability of the composition of the SDR currency basket; and continuity in the method of SDR valuation. In 2005 the IMF Board reaffirmed its 2000 decision which mandated that the SDR basket ‘comprises the four currencies that are issued by Fund members... whose exports of goods and services during the five year period ending 12 months before the effective date of the revision had the largest value, and that have been determined by the Fund to be freely usable currencies in accordance with Article 30(f) of the Articles of Agreement.’ Article 30(f) states that ‘A freely usable currency means a member’s currency that the Fund determines (i) is, in fact, widely used to make payments for international transactions and (ii) widely traded in the principal exchange markets.’
China, now the world’s largest exporter, meets the first criterion for SDR inclusion. But is its currency ‘freely usable?’ In 2010 the Fund concluded that the renminbi was not widely used to make payments for international transactions, or widely traded in principal exchange markets. Criteria included percentage turnover in daily foreign exchange trading; percentage of international bank liabilities denominated in the currency; and international debt securities in the currency in question.
While use of the renminbi as a settlement currency has grown rapidly in recent years, it is still relatively narrow. According to Society for World Wide Interbank Telecommunication data, as of October 2014, the renminbi was the seventh-ranked payments currency in the world, with a 1.6% market share. This places it behind the Australian dollar (2%) and Canadian dollar (1.8%), neither of which is in the SDR. Despite the enlargement of QFII and Renminbi Qualified Institutional Investor Quotas, China’s capital account is still closed, and its legal system, as emphasised in the recent Fourth Party Plenum, is not yet fully developed. It is understandable that some IMF Board members may take the view that the renminbi still does not meet current criteria for inclusion in the SDR and that the issue should be revisited only in the 2020 reconstitution. (The Fund could also review SDR composition ‘off-cycle’, or before 2020.)
The Board could revamp the criteria by which currencies are selected and weighted in the SDR. A study by Agnes Benassy-Quere and Damien Capelle of the Centre d’Etudes Prospectives et d’Informations Internationales argues that the ‘free usability’ criterion should be reviewed. Central banks can designate which currency of the constituent SDR currencies it would like in exchange for the SDR.
The study argues that, in the case of China, the ‘freely usable’ criterion is less relevant, as central banks will want access to a currency likely to appreciate. Market participants may not be convinced, as the ability to hedge inexpensively underlying investments is key. And there are no ‘one way bets’ in the currency market. If the renminbi were added to the SDR basket in 2016, its weight would be roughly 10.5%.
Several institutional gaps need to be met for a private SDR market to develop, including multiple market makers; continuous and transparent pricing; repurchase mechanisms; derivatives; technology infrastructure, and a ‘lender of last resort’. To the extent that a non ‘freely usable’ currency is added to the SDR, the private use of the SDR may be further frustrated. The renminbi’s share of world reserves will gradually rise, and the renminbi will one day be a constituent currency of the SDR. As part of its broader SDR initiative (first advanced by Zhou Xiaochuan, governor of the People’s Bank of China, in March 2009), China may wish to consider promoting the private use of the SDR. This initiative could begin by either borrowing in SDR, or investing in SDR instruments.
■ China’s renminbi initiative and dollar ‘hegemony’ Why criteria matter on the SDR George Hoguet, State Street Global Advisors George Hoguet is Global Investment Strategist in the Investment Solutions Group at State Street Global Advisors. Back