Here's how China’s renminbi becomes a new international reserve currency

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). China is pushing hard for the renminbi’s inclusion. Should it be admitted?

The IMF created the SDR in 1969 to supplement existing reserve currencies, thereby providing the global financial system with additional liquidity. As it stands, the SDR’s role remains largely limited to IMF operations; its share in global financial markets and central banks’ international reserves is negligible. Nonetheless, adding the renminbi to the SDR basket would be symbolically important, implying recognition of China’s growing global stature. The renminbi is already a major currency for world trade and investment, and accounts for a growing share of international financial transactions and reserve holdings.

To qualify for inclusion, the Chinese government has eased its capital controls and liberalized its financial markets considerably. Inclusion in the SDR basket would require continuing this process, which, together with the renminbi’s emergence as a globally investable currency, would benefit the entire world economy.

The IMF’s largest shareholders – the United States, Europe, and Japan – should thus welcome the renminbi’s addition to the SDR basket. Yet opinions on the matter have been divided, with 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. Although emerging economies have since accumulated larger foreign-exchange reserves and strengthened financial supervision and regulation, they remain vulnerable to external shocks, especially from the US, the eurozone, and Japan. All three have lately employed expansionary monetary policies; and, as the US Federal Reserve normalizes its policy, emerging economies will be hit again by a sudden withdrawal of global liquidity.

This continued vulnerability reflects a collective failure to reform the global monetary system – an imperative that People’s Bank of China (PBOC) Governor Zhou Xiaochuan highlighted in early 2009. Per Zhou’s proposal, 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. Last year, the Shanghai-Hong Kong Stock Connect was launched to stimulate cross-border investment and capital-market development. And China has signed bilateral currency-swap agreements with 28 central banks, including the Central Bank of Brazil, the Bank of Canada, the European Central Bank, and the Bank of England.
This year, 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, overtaking the euro, and the fifth most used for international payments. Moreover, it is increasingly preferred in currency-market transactions and official foreign-exchange reserves.