RMB's SDR Inclusion Revs up Globalizatio
By HE YAFEI
THE International Monetary Fund (IMF) announced on December 1, 2015 the inclusion of the RMB into its Special Drawing Rights (SDR) basket. The decision gave the RMB a weighting of 10.92 percent, after the U.S. dollar (41.73 percent) and the euro (30.93 percent) and ahead of the Japanese yen (8.33 percent) and the British pound sterling (8.09 percent). Effective in October 2016, the move marks a milestone in the RMB's global march.
Hastened RMB Internationalization
The SDR is an international reserve asset and unit account created by the IMF in 1969, in the context of the Bretton Woods fixed exchange rate system. Since the international supply of two key reserve assets – gold and the U.S. dollar – proved inadequate to support the expansion of world trade and the financial flows that were taking place, the SDR, also known as "paper gold," aimed at allowing a member, in the event of an international payment deficit, to exchange foreign currencies with other SDR members, either to balance its deficit or repay IMF loans. Besides, the SDR functions the same way as gold and convertible currencies in being an international reserve asset. The IMF reviews the basket composition every five years to decide if new currencies need to be included, judging by their status in the international trade and financial markets. The weighting of each SDR currency is accordingly adjusted.
Before the RMB was included, the U.S. dollar was weighted at 41.9 percent, the euro at 37.4 percent, the British pound sterling at 11.3 percent, and the Japanese yen at 9.4 percent.
Economic globalization in modern times demonstrates that the price factor plays a key role in a nation's economic strength and core competitiveness. For instance, in the 1860s, planting and manufacturing industries shifted from Europe to North America, where land was broader and cheaper. The new continent seized this opportunity to make itself the world economic center. Another example took place in the 1980s in Southeast Asia, which took the advantage of its rich yet economical labor resources to draw foreign direct investment and so beef up its manufacturing.
In addition, natural resources determine a nation's economic scale. China has always been considered a large country with an enormous population and abundant resources. It stood at the world forefront of economy and financing from the third century BC to the mid-19th century.
In the era of economic globalization, however, a country's capability to allocate worldwide resources, particularly capital, is decisive to its strength. Since the 20th century, global capital, technologies, human resources, and industrial chain divisions and combinations have influenced a country's command of the world's financial capital. An economic power should be capable of deploying resources worldwide. This is echoed in the expression "two markets and two kinds of resources" that Chinese politicians and economists often use, which refers to international and domestic markets and resources. Moreover, an economic heavyweight must also be a great financial power with a say in the flow of funds and technologies within the global labor division chains, as well as in determining labor divisions. It thus becomes ultimate allocator of production factors.
Today, China has become the world's largest manufacturing nation with the most complete industries, according to United Nations statistics. Meanwhile, Chinese enterprises are striving to go global. So far, more than 20,000 Chinese companies have ventured into overseas markets. Take Huawei for example. This leading telecom solutions provider has established branches and factories in 164 countries and regions. Moreover, Chinese customers' purchasing power in overseas markets has considerably increased in recent years. The RMB has evolved from its function of settlement currency to an investment and reserve currency to some extent, so displaying acceleration of the RMB's global march. China has signed more than RMB five trillion's worth of currency swap deals with 30 or more countries. The development of both China and other countries shows that it is only to be expected that a large manufacturing nation will develop into a financial powerhouse. This is, indeed, a necessary condition that guarantees China's successful transformation from a big manufacturer to an even stronger one.
Currency, the monetary market and a substantial economy are the pillars that support a financial powerhouse. Several requirements must be met in this regard.
To start with, the country's sovereign currency must go global and be capable of leading international economic and financial governance, and of shaping governance systems. The internationalization of a nation's currency requires proactive industrial competitiveness in the first place. Significant status in world economy and trade is important to a country, as is favorable opportunity. For instance, as a victorious nation and the one that benefited most from WWII, the U.S. made the dollar the world's reserve currency in 1944, as the war was drawing to an end. The war destroyed industrial systems in Europe and Asia, so new currency, international trade and investment systems needed to be built when it was over. The U.S. took the advantage of its status as a major world creditor nation, investor and manufacturer to develop an international economic and financial governance system that made the U.S. dollar the world's primary reserve currency and enabled it to denominate bulk commodities.
Facts show that the currency of a financial powerhouse is widely accepted in the fields of international trade and monetary markets, and can be used for international payments, foreign exchange trading, and state reserves. It is for this reason that the monetary policies of a financial heavyweight often produce a strong spillover effect – any move by its central bank, whether tightening or loosening, brings about changes in other countries' exchange and interest rates, as well as influencing global financial markets, staple commodity markets, and cross-border capital flows.
Second, a well-developed financial market with a strong ability to allocate global financial resources is required. A financial powerhouse usually owns one or more international financial centers that lead international currency, capital, and commodity market platforms through which the nation can grasp the right to allocate global economic resources and pricing power. The U.S. is again an example. The New York Stock Exchange and Chicago Mercantile Exchange set the benchmark prices for global financial products and bulk commodities. This makes it possible for the U.S. to absorb saving funds from other countries at a comparatively low interest rate while investing abroad via foreign direct investment to obtain high profits.
Third, a developed substantial economy must be matched with a financial system in order to realize sustainable development. The financial system in a power – often embodied in large-scale commercial banks, investment banks and insurance companies that are internationally competitive and have influential status – must be sound, effective, flexible and competent.
China's financial system, however, still cannot meet those criteria. Among the world's top 10 banks ranked according to their tier 1 capital in 2015, only four were from China. Besides, China's commercial banks own fewer overseas assets than their counterparts in developed countries. Although the Industrial and Commercial Bank of China is at the fore, its overseas assets take up just 10 percent of its total assets. In addition, China's commercial banks failed to be ranked among the top 10 global systemically important banks listed by the Financial Stability Board in 2014. In 2015, banks from the U.S. and Europe had equal shares in the list of the 10 largest investment banks worldwide, but there was no room for their Chinese counterparts.
Having entered its "new normal" period, China is undergoing transformation of its growth mode and upgrade of its economic structure. Its role as a recipient is consequently changing to that of exporter of capital and technologies. This symbolizes a turning point on the way to becoming a financial heavyweight. To this end, China needs to improve its financial system to make it more efficient, stable and open. Only then, with the support of its economic, military and diplomatic strengths, can China compete for pricing power in the international financial market and hold allocation rights over world economic resources. It may thus enjoy the right to issue international currency as well as gains from seigniorage at the international level.
Worldwide Influence
It was not easy for the RMB to make current achievements during its globalization process. We must continue working hard to build the country into a financial power. How should we evaluate RMB's SDR inclusion?
First of all, by virtue of inclusion in the SDR basket and of becoming an international reserve currency, the RMB is expected to contribute to perfecting the international monetary system. The People's Bank of China, the nation's central bank, has pointed out that the RMB's SDR inclusion is a win-win result for China and the world. This is because it plays an active role in enhancing the SDR's representativeness and appeal as well as perfecting the current international monetary system. Generally speaking, the world displays a positive attitude towards RMB's SDR inclusion.
Since the financial crisis of 2008, the international financial system ruled for decades by the U.S. dollar has been placed in greater risk. The world calls for a more balanced and equitable monetary system, and places hopes in this regard in the RMB. On the other hand, although developing countries take up 40 percent of the world's GDP, they have not gained due rights of representation and, taking into consideration their contributions, of speaking in the international monetary system. Developing countries demand reforms to the international monetary system, but face serious obstacles. Reform to the International Monetary Fund (IMF) and the World Bank, as decided by the leaders of the G20 countries in 2009, has been avoided until today. Clearly, action must be taken to change the predicament wherein the international monetary system is under criticism yet unable to change the status quo.
The RMB's SDR inclusion is expected to contribute to the international monetary system in terms of stability, representativeness, and legitimacy. For example, currencies in seven East Asian countries now have closer ties with the RMB than they do with the U.S. dollar. When the RMB appreciates by one percent, the currencies in these seven countries appreciate by 0.55 percent. However, if the U.S. dollar appreciates at the same rate, these currencies rise by just 0.34 percent.
What's more, the RMB's SDR inclusion facilitates China's financial reform, which will boost the RMB's competence in the global market. This demonstrates China's resolution in carrying forward its financial reform, notably opening-up of its capital accounts. Financial reform has always been an important part of the pilot moves carried out in the free trade zones in Shanghai, Fujian, Guangdong, and Tianjin.
According to IMF officials, China is changing its exchange rate system from that of pegging the RMB to the U.S. dollar to one that is more open, flexible and market-based. The RMB is expected to float freely in the coming two or three year. Even though at this stage we cannot guarantee this will be fulfilled, there is no doubt that reform of the financial system will not cease and that it will advance in three facets. First, by relaxing restrictions on the issue of RMB bonds and supporting issuance by government bodies and domestic enterprises of RMB bonds abroad. Second, by promoting two-way opening of the stock market while allowing overseas companies to carry out equity financing in China's inland, and encouraging qualified individual investors to invest abroad. Last, by improving the global RMB payment system after it comes into effect.
Internationalization of the RMB sped up remarkably in 2015. According to a report issued by the Society for Worldwide Interbank Financial Telecommunications (SWIFT), at the end of August 2015, the RMB had surpassed the Japanese yen to become the world's fourth-largest payment currency. SWIFT statistics show that the RMB's global payment market share was 2.79 percent, that of the U.S. dollar was 44.82 percent, that of the Euro 27.2 percent, the British pound sterling's was 8.45 percent and the Japanese yen's 2.76 percent. On top of that, the RMB has become the second most used currency in trade finance. Moreover, a currency in the SDR basket is a foreign exchange reserve asset for other countries. Therefore, the RMB will showcase the significant influence of being a reserve asset.
First of all, many countries have used RMB as part of their reserve currencies. But the total quantity is not yet immense. Being included in SDR basket, however, will undoubtedly increase the RMB proportion in each country's reserve currencies, and stimulate the world demand for the currency. Standard Chartered and AXA Investment Managers estimate that by the end of 2020, US $1 trillion will be switched to Chinese assets.
Secondly, the inclusion bolsters confidence in China's economy and currency at the strategic level. Take the bond market as an example. Deepening financial reform in China brings positive influence on different facets of the bond market. Viewed from the medium-term, interest arbitrage will keep drawing overseas capital. But it will be removed in the long run by descending bond yields. Moreover, global investors venturing into the Chinese market may expand interest rate elasticity along with yield curve effectiveness. Besides, integrating credit ratings in China with international standards will help narrow the gap between the domestic and global rating systems.
Overseas investors occupy just 2.4 percent of China's bond market which has a total value of US $40 billion. However, the figure in India stands at 5.7 percent, in South Korea at 6.5 percent, in Thailand at 18.6 percent, in Malaysia also at 18.6 percent, and in Indonesia at 36.5 percent. China's potential and opportunities hence need to be dug out. Opening up the domestic bond market may slow down outflows of domestic and foreign capital, which is important at the current stage wherein the RMB may depreciate.
Strategic confidence will lead to a rising demand for RMB assets, and expand the gap between demand and supply, especially in investment and hedge funds. Bank for International Settlements statistics reveal that at the end of the second quarter 2015, outstanding global bonds and bills stood at US $20.67 trillion, 42.66 percent of which were priced in U.S. dollars, while 39.16 percent were priced in euros, 9.62 percent in British pounds sterling, and 1.95 percent in Japanese yen. With a weighting of 10.92 percent in the SDR basket, outstanding international bonds and bills priced in RMB take up around 10 percent, which means that a deficit of US $2 trillion currently exists in the market. This amount equals the sum of China's new bank loans in 2014 valued at RMB 9.78 trillion, and its new corporate debt financing worth RMB 2.42 trillion.
At present, the total the RMB's SDR quota is only US $280 billion, taking up 2.5 percent of global reserve assets. Whether a sovereign currency is a global reserve asset is judged by such criteria as the country's macroeconomic conditions, perfection of its financial system, and the openness of its capital market. The Canadian dollar and Australian dollar, although not included in the SDR basket, are global reserve currencies. Hence, SDR inclusion is only one of the symbols of the RMB's internationalization rather than its ultimate goal.
Future Moves
China is expected to advance sustainable economic development, perfect its financial system, enhance the depth of the capital market and stabilize global anticipation of the RMB, so making the RMB a major global reserve currency.
First, RMB internationalization will be beefed up. China will continue to be proactive in international financial governance and financial system reforms. Based on the reforms smoothly carried out to liberalize the capital account and RMB exchange rate, the RMB's global march must speed up in order to become a freely convertible currency as early as possible. By the end of 2020, the use of RMB for cross-border transactions should make up 35 percent of the use of both of its own and foreign currencies in China's cross-border transactions. The figure in 2014 was 23.8 percent.
Meanwhile, China's major-country diplomacy plays its role effectively. New international financial institutions, including the Asian Infrastructure Investment Bank, the BRICS New Development Bank and the Silk Road Fund, provide platforms to build new structures within a comprehensive opening-up, and to increase China's influence and voice in multilateral economic and financial organizations. China is encouraged to speak out boldly, to uphold justice, and to reflect the demands of developing countries in order to establish a fairer, more equitable and reasonable system of international economic and financial governance. The country, at the same time, will be involved ever more deeply in the global economic system.
Next, China endeavors to expand the scale and depth of the financial market, build up a modern financial system, and advance the level and efficiency of services that finance provides for a substantial economy. It adheres to the principle of giving equal importance to investment and financing in the financial market, while developing a multi-level capital market and increasing the proportion of direct financing. The stock market system will be further improved, the proportion of equity financing increased, and the marketization of resources allocation realized. In addition, the country needs to unify regulations in its bond market to promote efficiency and liquidity. Expanding two-way opening-up of the financial market will heighten the level of internationalization.
To better serve a substantial economy, technological facets of the financial system must be perfected to conform to the national strategy of innovation-driven development. The development of green finance will boost the country's economic transformation and progress in a more environment-friendly way. The country also upholds inclusive finance, and vows to give more financial support to small and micro businesses, as well as to the three agriculture-related issues of agriculture, farmers, and rural areas.
Last but not least, China will build a financial supervision system according to international standards, and stick to the bottom line of avoiding systematic and regional financial risks. New financial modes like shadow banking and Internet finance are emerging against the backdrop of deepening economic reform and the "Internet Plus" strategy, which requires higher levels of management and safety. Financial situations at home and abroad since 2008 imply that the specter of another global financial crisis constantly lurks. Therefore, a perfected financial supervision system is of great importance to China. The central bank should strengthen its supervision over systematically important financial institutions to form a reliable safeguarding system while building China into a major financial power.
HE YAFEI is deputy director of the Overseas Chinese Affairs Office of the State Council and former vice minister of foreign affairs.
