New status for renminbi

Pros and cons of China's yuan becoming a reserve currency

A few months ago, global markets were shaken by the Chinese authorities' decision to depreciate the yuan, or renminbi. The official position was that this was one significant step in the liberalisation of the currency regime and that the fact that the renminbi moved downwards was simply a reflection of market conditions. However, many observers took a different view, attributing the move to China's growing concern that its exports were slowing, exacerbating the already sluggish growth situation. The real test, they suggested, would be when the pressures on the currency were reversed; would the authorities then allow an unimpeded appreciation? That question must remain unanswered for now. The official version is set to be endorsed by the global financial system as the renminbi is set to be inducted into the International Monetary Fund's Special Drawing Rights (SDR) portfolio, the first new currency to be brought in since the euro was created. The SDR basket is the basis of the IMF's lending, reflecting a combination of the world's most liquid currencies and hence suitable for any country that needs support for its balance of payments. The renminbi's inclusion confers on it that same status. It effectively becomes a reserve currency, affording China the flexibility of settling all its external obligations with its own currency (what has been described as an "exorbitant privilege"). Other countries can now diversify their forex reserve portfolios to hold renminbi. In some fundamental ways, this is a coming of age for the Chinese economy, a clear recognition of its status as the world's second-largest economy.

Some would question this exalted status. There is, of course, no question about the importance of China both in terms of its share in the world's gross domestic product and, perhaps, even more important, its share of world trade. Most of the advanced economies and many others, including India, have large bilateral deficits with China. Others, primarily energy and commodity exporters, have surpluses. With the renminbi as a reserve currency, the latter group could enter into trade with the former in a global currency exchange. This would help create a genuine market, which is a critical requirement for a reserve currency. There is already a growing offshore renminbi market operating in London, which can provide the basis for this requirement. The question really is whether China can live with currency volatility in both directions, but, as indicated earlier, this is yet to be tested; it is currently a matter of faith.

On the negative side, the question is how countries will hold the currency. Forex reserves held in dollars or euros can easily be invested in government securities denominated in those currencies, for which there are large and liquid markets. China would have to nurture such a market, with large volumes and easy entry and exit, to induce countries to hold renminbi reserves. Thus far, the general assessment is that the markets in renminbi-denominated securities either do not exist or are in very early stages of development. This will remain a sharp difference between the renminbi and the other currencies in the SDR portfolio. Clearly, getting up to speed quickly on this will be a priority for Chinese financial sector policy.