National Security & Defense

The Dollar — Not China — Gets a Boost from the IMF

(Kevkhiev Yury/Dreamstime)

The IMF has added China’s renminbi to the basket of currencies it uses to determine the value of its special drawing rights. The move might appear to signify a global leadership role for China in finance. In fact, it is a largely political decision by the IMF, one that may eventually serve to discourage the rise of the renminbi (RMB or yuan).

Special drawing rights (SDRs) are an accounting tool for IMF transactions, including support for member states. Since the IMF does not produce anything of value, the SDR is merely a derivative of its constituent currencies. As of October 1, 2016, the dollar will have 42 percent weight in the basket that makes up the SDR; the euro, 31 percent; the RMB, 11 percent; the yen, 8 percent; and the pound, 8 percent.

The symbolism of the addition of the RMB is in the eye of the beholder. Probably most important, it will appeal to nationalist sentiment in China, especially with the RMB having higher weight than the yen. It might also trigger a portfolio shift, with central banks and other financial actors seeing an IMF seal of approval and feeling more confident in holding RMB and RMB-denominated assets.

Central banks often do strange things, but buying a substantial amount of RMB on the basis of its inclusion in the SDR would be impressively strange. This is because the RMB not only falls short as a reserve currency, it also falls short as an independent currency.

The RMB is pegged to the dollar, and quite tightly. It follows the dollar’s every stutter and hitch against the euro, as well as every other currency. It is absurd to talk as if the RMB is challenging the dollar as the global reserve currency. The RMB is the dollar, painted red.

Adding the RMB to the SDR basket, therefore, will boost the weight of the dollar past 50 percent. While some RMB buying might occur for essentially diplomatic reasons, any central banks purchasing a sizable quantity of RMB are purchasing a dollar instrument and presumably will do so largely on the basis of the dollar’s value.

#share#Why is the IMF treating a dollar instrument as a global reserve currency? The answer is politics, some silly and some not.

The silly part is pretending that RMB internationalization has been meaningful to this point, pretending that the RMB is comparable to the pound, for instance. Most “international” use of the RMB occurs in Hong Kong, a financial center, to be sure, but a financial center inside China. Much-touted currency swaps with various other countries are typically diplomatic rather than financial in nature.

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And, as with its inclusion in the SDR basket, swapping or using the RMB is effectively just swapping or using the dollar. RMB internationalization has chiefly served the purpose of increasing global reliance on the dollar.

There are just two steps that actually matter with regard to RMB internationalization: breaking the link to the dollar and allowing money to move freely in and out of China (opening the capital account). The IMF decision will have a substantial impact only if it affects the likelihood of Beijing’s taking these steps.

Right now, the dollar is a powerhouse, climbing against the euro and others and dragging the RMB along for the ride.

If the link to the dollar were broken, the RMB would finally be its own currency. Right now, the dollar is a powerhouse, climbing against the euro and others and dragging the RMB along for the ride. The RMB is overvalued and would fall if permitted. A cheaper RMB could change trade patterns and would inflame trade tensions.

Liberalizing capital movement receives less attention but is more important. Right now, even with capital movement still controlled, money is leaving China both for conventional investment and as flight capital away from a weakening economy and Communist Party General Secretary Xi Jinping’s internal crackdown.

Heading in the other direction, China’s turbulent stock and bond markets are not attractive to foreign investors. Capital account liberalization would thus lead to a large net outflow from an already weak Chinese financial system, which is exactly why Beijing avoids it.

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These considerable problems mean fundamental reform affecting the RMB is a ways off. If the IMF’s decision brought that day closer, it would be valuable. More likely, however, it will cause Beijing to be more cautious about external financial reform or even to declare victory and halt that process.

#related#Weighing against reform are twin risks of currency instability (when Beijing has long been praised for keeping the RMB stable) and financial instability (when China has an unprecedented debt problem that could take decades to fix). Now also weighing against reform is the ability to claim that the IMF has already recognized the yuan as a market-driven currency and accepted China’s capital controls.

If Xi Jinping is indeed fully committed to an independent RMB and free capital movement, SDR inclusion is an endorsement of the path China was previously set on. If he is not committed or his commitment can be swayed, then the IMF has provided an excellent excuse for deeming further reform unnecessary.

The initial effect of the IMF’s pretending that the RMB is a global currency is to boost the currency the RMB depends on — the dollar. Ironically, the long-term effect may be to put off the day when the RMB truly becomes a global currency.

— Derek Scissors is resident scholar at the American Enterprise Institute and chief economist for China Beige Book.


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