Originally published on Project-Syndicate.org | August 5, 2015
The Chinese have a saying: “Take a second look; it costs you nothing.” This advice is apt in the context of China’s current stock-market volatility, the implications of which extend to the country’s core strategic goal of establishing the renminbi as a global reserve currency.
LONDON – The Chinese have a saying: “Take a second look; it costs you nothing.” This advice is apt in the context of China’s current equity-market volatility, the implications of which extend beyond the immediate anxiety that the recent turbulence has provoked. In fact, this turmoil should be viewed in light of one of China’s core strategic goals: to establish the renminbi as a global reserve currency.
The renminbi’s potential to serve as a reserve currency has gained increased attention this year, as the International Monetary Fund prepares to review the currency basket that determines the value of its own reserve asset, the Special Drawing Right. The SDR was created in 1969 to supplement member countries’ official reserves. China has been campaigning for years to have the renminbi included in the basket, alongside the US dollar, the British pound, the euro, and the Japanese yen.
China’s push to secure reserve-currency status for the renminbi is understandable, given the far-reaching benefits of such a change. It would make the currency more stable and reduce the need to hold massive reserves. With policymakers no longer forced to suppress domestic demand to sustain a high level of reserves, consumption could supplant fixed-asset investment, placing China’s economy on a more sustainable growth path. Excess reserves could be allocated to sovereign wealth funds and finance projects – including through the new Asian Infrastructure Investment Bank – that extend the country’s global influence.
The IMF has claimed that the recent disruption in the stock market will not affect the renminbi’s chances of joining the SDR basket. The Fund prefers to focus on a “well-defined set of criteria,” including efforts to open the financial system and develop capital markets.
But inclusion in the SDR basket is neither necessary nor sufficient to achieve true reserve-currency status. The SDR accounts for just 2% of total central-bank reserves, and it is not used by the private sector at all. In fact, the four-currency basket has not changed for 15 years, largely because of its lack of significance.
Of course, the renminbi’s inclusion in the SDR basket would be an important symbolic milestone on the renminbi’s path to full internationalization. But that path will be long and hard, with the government forced to overcome major economic obstacles, including extreme asset-price volatility, along the way.
At a minimum, a reserve currency must be freely convertible for current-account transactions, such as commercial trade and interest payments. To attain genuine reserve-currency status, however, it must also be freely convertible for capital-account purposes, such as foreign direct investment. Most important, central banks require liquidity denominated in a reserve currency to meet balance-of-payment requirements, to service debt, and occasionally to intervene in foreign-exchange markets.
To achieve this, the country supplying the reserve currency needs a large domestic capital market – in particular, for short-term, high-quality debt securities – in which central-bank reserves can be held. In the United States, Treasury bills serve this purpose, while in the United Kingdom, there is a large, liquid pool of short-term gilts. But China’s government-debt market, the most likely repository for reserve assets, remains too small and illiquid for the purposes of central-bank reserve managers.
Beyond maintaining convertibility, a country must accept “excess demand” for its currency and supply it freely. In practice, this means that China would need to run a chronic current-account deficit, which it may not be willing to do. At the same time, the rest of the world may not be willing to build up claims against China – at least not on the scale required for a viable reserve currency.
Even if Chinese authorities managed to achieve full convertibility and tradability for the renminbi, there is no guarantee that it would actually become a global reserve currency for the simple reason that reserve currencies are not easily established. Indeed, over three centuries of globalization, only three “currencies” have dominated: gold, the British pound, and the US dollar. Though the Deutschemark, the Swiss franc, and the Japanese yen have all offered viable alternatives to the dollar since World War II, often providing better stores of value that are less prone to inflation, none has made lasting inroads into the dollar’s share of global foreign-exchange reserves.
It is also perhaps no accident that global financial centers and reserve currencies have emerged largely in countries where the rule of law is well established, and where foreigners do not face potential legal discrimination. Whether China can achieve similar legal standing remains to be seen; at the very least, it would be a long and slow process.
China continues to take some of the necessary steps to reach reserve-currency status. Maybe these will prove sufficient for the renminbi to be added to the SDR basket this year. But, as China’s equity markets have recently shown, the path is likely to be a bumpy one.
