Thomas Laryea and Alex Wang, Dentons, take a look at the significance of the International Monetary Fund decision to include China’s renminbi in the basket of currencies the IMF uses to calculate the value of its reserve asset, the SDR.

The inclusion by the International Monetary Fund (IMF) of China’s renminbi (RMB) in the basket of currencies used to calculate the value of the Special Drawing Right (SDR – the IMF’s reserve asset) is a notable development in the international financial system.

‘The [IMF] Executive Board’s decision to include the renminbi in the SDR basket,’ commented the IMF’s Managing Director, Christine Lagarde, ‘is an important milestone in the integration of the Chinese economy into the global financial system. It is also a recognition of the progress that the Chinese authorities have made in the past years in reforming China’s monetary and financial systems. The continuation and deepening of these efforts will bring about a more robust international monetary and financial system, which in turn will support the growth and stability of China and the global economy.’

In order to understand this development and its likely direction, it is important to comprehend what the IMF did (and did not do) on 30 November 2015, its place in history and what this signals for the future.

What is the SDR?

The SDR is an international reserve asset created by the IMF to supplement official reserves of IMF member countries. At the time of the SDR’s creation in 1969, the international monetary system operated under the so-called gold standard in which currencies of IMF member countries were required to be in fixed parities based on gold (or more precisely other currencies were in fixed parity with the US dollar whose convertibility to gold was guaranteed).

During the gold standard, one unit of SDR was valued as equivalent to 0.888671 gram of the fine gold value of the US dollar in 1944 (when the IMF was established). With the collapse of the gold standard in the early 1970s due to the inability of the then high inflationary US economy to credibly guarantee fixed US dollar convertibility to gold, the IMF sought to wean the global financial system away from gold/US dollar dependency and instead the IMF sought to promote the SDR to become the ‘principal reserve asset in the international monetary system’.

Ironically, a limitation in the SDR’s capacity to play such a central role has been a provision in the IMF’s international legal treaty, the Articles of Agreement, which limits the circumstance in which the IMF can allocate SDRs to IMF member countries, namely where the IMF determines that there is a need for additional global liquidity. Based on this legal provision, the IMF has decided to allocate SDRs on only four occasions, the last of which was in 2009 during the liquidity crunch of the global financial crisis. At that time, SDR 182.6 billion was allocated, out of a total of SDR 204.1 billion that has been allocated to date. The volume of allocated SDRs is miniscule compared to the around 11.5 trillion of foreign exchange reserves held by central banks, around 65% of which is denominated in US dollars. (Notably, China represents the largest holder of US dollar reserves. Conversely, only 1% of global foreign exchange reserves are held in RMB). In addition to the constraints on allocation of SDRs, the use of SDRs is also limited by the IMF’s Articles of Agreement: to use in payments among IMF member countries, by the IMF itself and by certain official entities prescribed by the IMF (such as the Bank for International Settlements). Accordingly, the SDR cannot be used for payments by private parties, who in the modern day are a major component of the global financial system.

The decision by the IMF on 30 November 2015 is not directly related to the allocation or use of SDRs. Rather, the decision is focused on the valuation of the SDR. The IMF’s methodology for determining the value of the SDR is based on a basket of currencies, which currently comprises the US dollar, the euro, the Japanese yen and the UK sterling. The composition of this currency basket depends on two criteria:

  1. currencies that are issued by IMF member countries or monetary unions whose exports had the largest value over a five-year period, and
  2. currencies that have been determined by the IMF to be ‘freely usable’.

With China as the third largest export country in the globe, the first criterion was met with little debate. But questions had been raised as to whether the RMB could be characterised as ‘freely usable’ within the terms of the IMF’s Articles of Agreement. The relevant provision in the IMF’s Articles of Agreement defines a freely usable currency in relation to whether the currency is widely used to make payments for international transactions and is widely traded in the principal exchange markets. This definition is not the same as that for a ‘freely convertible’ currency, although in practice controls on a currency can limit its wide international use, as had arguably been so in China’s case. In order to dispel such questions, the Chinese authorities have continued to introduce a series of measures to liberalise the foreign exchange regime and to moderate controls in relation to the RMB.

China’s progressive liberalisation of foreign exchange and RMB controls

China’s approach to its progressive liberalisation of foreign exchange controls broadly reflects the distinction made in the IMF’s Articles between:

  1. international payments for current transactions, which IMF member countries are generally required to liberalise, and
  2. international capital movements, with respect to which IMF member countries generally preserve freedom to restrict.

Accordingly, the Chinese government has substantially lifted foreign exchange controls in relation to current account transactions (for example, payments for imports). Chinese companies are no longer required to obtain an approval from the State Administration of Foreign Exchange (SAFE) or its local counterpart to open a foreign exchange account for the purposes of engaging in current account transactions and for these transactions Chinese companies are generally allowed to convert their onshore RMB into foreign currencies, remit the same offshore or retain their foreign currency revenues either onshore or offshore, without being subject to a foreign exchange quota.

China has also relaxed foreign exchange controls on capital account transactions in the past decade. Most outbound investment projects (except for those involving sensitive industries or regions) to be pursued by Chinese domestic investors are now only required to be filed with – and not approved by – the Chinese authorities before the private parties are allowed to convert their onshore RMB funds into foreign currencies for the purpose of making the relevant outbound transactions (which generally include green field investments and M&A transactions, but exclude investments in offshore capital markets).

In 2006, the Chinese government introduced a Qualified Foreign Institutional Investors (QFII) scheme. This scheme opened a gate to qualified foreign institutional investors to invest in Chinese capital markets within a foreign exchange quota. In the next year, the Chinese authorities rolled out a Qualified Domestic Institutional Investors (QDII) scheme, which allowed qualified Chinese financial institutions to make investments in qualified offshore capital markets, also within a foreign exchange quota.

Furthermore, the Chinese authorities’ effort to expand the use of RMB in international transactions was precipitated in July 2009, when China’s central bank launched a pilot scheme allowing domestic companies in certain pilot regions to directly use RMB for cross-border trading settlements. This scheme was expanded nationwide in 2011. Starting from January and October 2011 respectively, Chinese domestic companies have been allowed to make outbound direct investments and foreign companies have been allowed to make inbound direct investments using RMB funds. In December 2011, China introduced a RMB Qualified Foreign Institutional Investor (RQFII) scheme. This scheme enables qualified foreign institutional investors to utilise RMB funds for their investments in Chinese capital markets. Subsequently, in November 2014, a similar scheme (RMB Qualified Domestic Institutional Investor—RQDII) was launched to allow qualified domestic institutional investors to use RMB funds to invest in qualified offshore capital markets. These measures and others demonstrate the Chinese authorities’ resolution to turn RMB into a more freely convertible and internationalised currency.

A journey for the IMF, China and others

As noted by the IMF Managing Director, the approach of inclusion of the RMB in the SDR basket of currencies, also represents a journey for the IMF and not just for China. It is a far cry from the stand-off experienced between the IMF and China less than a decade ago over whether the IMF, in exercise of its quasi-regulatory ‘economic surveillance’ function, would determine the exchange rate of the RMB to be ‘fundamentally misaligned’. The approach with regard to the SDR also side-steps – or at least mitigates the frustration of China (and other fast growing emerging market economies) – that have been waiting for IMF governance reform to provide them with greater economic weight and voting power within the institution. Notably, two weeks after the IMF’s decision to include the RMB in the SDR basket of currencies, the US Congress adopted legislation authorising the US government to agree to the IMF governance reforms.

The effective date of the IMF’s determination of the RMB as a freely usable currency and its inclusion in the SDR basket of currencies has been deferred to 1 October 2016 in order to allow time for adjustment within the IMF’s operations. At that time, the new respective weights of the SDR currencies will be: 41.73% for the US dollar; 30.93% for the euro; 10.92% for the Chinese RMB; 8.33% for the Japanese yen; and 8.09% for the UK sterling.

While we can today say that a milestone for China’s ascendency in the global economy has been reached, it will probably take many years for central banks and other asset managers to increase materially their holdings in RMB denominated assets. However, we can expect the Chinese authorities to immediately promote greater use of RMB in the international financing of the government and the corporate sector. For example, with the announcement on 4 December 2015 at the Forum on China-Africa Cooperation of China’s commitment of US$60 billion in financing to the African continent over the next three years, we can expect an increasing proportion of such financing to be denominated in RMB. This is merely one illustration of the growing importance of understanding China’s currency regime for actors engaged with China’s increasing global economic influence.

 

Thomas Laryea and Alex Wang
Dentons

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