On Monday, the Executive Board of the International Monetary Fund (IMF) voted to add China’s currency, the yuan or renminbi, to a very short list of elite global reserve currencies. Next fall, the yuan will officially be added to the IMF’s Special Drawing Rights (SDR) basket of currencies, which presently includes just the dollar, euro, yen and pound sterling. In part, the decision reflects the undeniable reality of China’s economic rise. However, the decision is also a pragmatic, perhaps even savvy, move by the IMF and the United States to further incorporate China into an international financial order that largely reflects Western economic ideas and interests.
The SDR is sometimes referred to as a “synthetic currency.” Its value changes daily and is based on a weighted combination of the four—soon to be five—currencies that make up the basket. From a practical standpoint, SDRs do not really matter very much. Their most prominent role is as a unit of account for the IMF. For example, the IMF officially reports its own assets and liabilities in SDR terms.
Despite that, inclusion in the SDR basket has symbolic value. It can be thought of as the IMF’s official endorsement of the yuan as a global investment and trade settlement currency. Central bankers as well as asset managers of private investment funds take the IMF’s opinion on such matters seriously. One major global bank predicts that the currency’s new status will generate $1 trillion in new investments in China over the next year. That could increase to $3 trillion over five years.
Yet, by some accounts, the yuan is not yet deserving of its new lofty status. One key requirement for inclusion in the SDR basket is what the IMF calls the freely usable standard. As recently as this spring, U.S. Treasury Secretary Jack Lew publicly stated that the yuan did not yet belong in the basket because “further liberalization and reform” was necessary to meet that IMF standard. Implicitly, Lew was pointing to two complaints the U.S. regularly makes about China’s currency policy. First, Beijing still tightly manages the yuan’s exchange rate, rather than allowing the market to drive its value. Second, the yuan is not a so-called fully convertible currency, as Beijing limits how much cash can move both in and out of its domestic financial markets.
Why did the U.S. change its position from opposing the yuan’s inclusion in the spring to supporting it by the fall?
However, earlier this year, the IMF issued a report that noted that “freely useable” simply means a currency is widely used to make payments for international transactions and widely traded in foreign exchange markets. On these standards, the yuan scores relatively well.
In recent years, the yuan has surged to become the second most popular currency in international trade financing deals and, overall, is now the fourth most widely used currency in international payments of all types. Nevertheless, the yuan still does not rank as a top five currency in global debt markets, currency trading or foreign exchange reserves.
In short, the yuan had a solid economic case for IMF inclusion—but not an overwhelmingly strong one. So, why did the U.S. change its position from opposing the yuan’s inclusion in the spring to supporting it by the fall? The answer comes down to politics.
Since at least 2009, China’s top central banker, Zhou Xiaochuan, has made getting his country’s currency in the SDR basket something of a personal crusade. Zhou is an economic reformer. In his tenure as governor of the People’s Bank of China (PBC), he has overseen a long list of policy changes that have opened China’s financial markets up to the world—albeit slowly and incrementally.
Financial liberalization poses some risks for key interest groups in China, not least of which are major export-oriented industries. Despite these risks, Zhou was able to push forward, in part, by dangling the prestige of SDR membership in front of the country’s leadership. Had the IMF thumbed its nose at the yuan—as it did in 2010—Zhou’s reform strategy, as well as his leadership at the PBC, may have been questioned in Beijing. Rejection would have been a blow to the financial reform movement in China and may have brought about backsliding. That was an outcome that the U.S. and IMF leadership wanted to avoid.
On the other hand, voting to include the yuan in the SDR basket hands a clear victory to Zhou and his vision of a more open Chinese financial system. It encourages continued incremental liberalization by demonstrating that the U.S.-dominated institution is willing to give China more power, so long as Beijing makes an effort to meet the IMF’s standards. This point bears repeating: Demonstrating that the IMF can serve China’s interests as well as America’s is vital for both the IMF itself and the international financial order that it presides over.