The renminbi and the SDR

5 October 2016

The IMF included the renminbi in the Special Drawing Right (SDR) basket effective 1 October. This is only a small step towards needed reform of the international monetary system but potentially a giant leap to signal that change is on its way. While the international economy has changed dramatically with the increasing importance of China and emerging markets, the international monetary system has remained broadly the same. If the system changes it will likely cause considerable upset.

The international monetary system, the network of central banks to maintain adequate liquidity in foreign exchange rate markets to support orderly international transactions, does not function as intended. Repeated bouts of sharp exchange rate volatility amid adverse policy shocks or otherwise indicate that exchange markets remain inadequate. Persistent large external imbalances show that the system continuously fails to induce adequate incentives for economic policies to be consistent with balanced international growth. This threatens overall stability.

Exchange rates matter. Sharp exchange rate adjustments alter a country’s terms of trade, affect its international competitiveness, economic prospects and employment. In international investments, if one had invested in equities over the last 10 years via the MSCI All Country Europe price index and one’s base currency was dollars, one would have had an average annual negative return of 1.7 percent. If one’s base currency was sterling, one would have had a positive return of 2.1 percent; over the last 12 months, the return in dollars would have been negative 1.4 percent and in sterling positive 16.8 percent. British tourists will find that their stay abroad has become significantly more expensive after the Brexit vote.

Historically change in the system caused large permanent exchange rate realignments. Silver depreciated significantly with the introduction of the gold standard in the 19th century. Sterling declined with the adoption of the dollar as the principle international currency in the second half of the 20th century. Under the Bretton Woods system, the yen was fixed at 360 yen per dollar through 1971; it is now trading at about 100 yen today.

The international monetary system has remained highly dependent on the dollar. The dollar continues to be by far the dominant currency to conduct international transactions outside the Euro Area. This has had many advantages but also increasing disadvantages. The Federal Reserve does not manage monetary conditions with an eye on external needs for dollars.

Renewed interest in the SDR is indicative of an increasing consensus that more international currencies are needed to manage the international economy effectively. The inclusion of the renminbi into the SDR basket is the first time the basket—currently comprising the dollar, euro, sterling and yen—is expanding. The SDR basket started with 16 currencies in 1974 after the demonetisation of gold. It was then reduced to 5 currencies in 1981 and with the introduction of the euro to 4 currencies. The changes occurred in large part amid a shift in the view of the IMF that the SDR rather than reducing dependence on national currencies should have attributes akin to a financial instrument to substitute the dollar. This could now reverse.

The SDR itself will not alter the performance of the international monetary system. It is held only by central banks and almost exclusively used for transactions within the IMF. There are only about 286 billion dollars of SDRs outstanding.

The SDR inclusion will require China to maintain a freely accessible renminbi and maintain and pursue further current and financial account liberalisation. But if the SDR is to gain in importance and the inclusion of the renminbi is to be more than simply symbolic, the amount of SDRs outstanding needs to increase considerably.

The inclusion of the renminbi followed intense lobbying by China. China sees the SDR as a vehicle to promote internationalisation of the renminbi as a natural attribute of its economic power. Large emerging markets may follow. China now needs to ensure there will be a significant increase in SDRs either within the IMF or more likely outside it possibly by revisiting an older proposal to swap dollars for SDRs through a so-called substitution account.

International investors surprisingly seem to care little about the system. 1 October is improbably a turning point. But if it is, it may be one of the most significant events for the functioning of the international economy. Investors better take note.

SDR basket