Should China Be Ejected from the SDR?

SANTA BARBARA – Last week, the Chinese government tightened its grip on the renminbi’s exchange rate. China has now effectively reneged on a promise it made 18 months ago, when it lobbied its way into the basket of currencies that determines the value of the International Monetary Fund’s synthetic reserve asset, the Special Drawing Right (SDR).

China’s latest move will hardly strengthen confidence in its currency. As some of us warned at the time, the renminbi’s admission to the SDR basket was a highly political decision that could have adverse long-term consequences. The basket had previously comprised the US dollar, the euro, the British pound, and the Japanese yen – all world-class currencies that meet the IMF’s two criteria for admission: they are issued by the world’s leading exporters, and they are “freely usable,” meaning that they are widely exchanged worldwide.

By contrast, the renminbi met only the first criterion when it was included in the SDR. Although China was already the world’s largest exporting country, its financial markets were primitive, and its currency plainly fell far short of being freely usable. In 2015, the renminbi ranked seventh in global central-bank reserves, eighth in international bond issuance, and 11th in global currency trading; and it remained non-convertible for most capital-account transactions.

Still, the renminbi was admitted. China had made it abundantly clear that it would not be happy with a negative decision, and no one wanted to poke the dragon. But rather than upholding its usual standards, the IMF and its principal members settled for China’s vague promise to make the renminbi more usable sometime in the future.

Historically, the People’s Bank of China (PBOC) had fixed the renminbi’s exchange rate on a daily basis, without regard to underlying market sentiment; and it had allowed for the renminbi to trade only within very narrow limits. But even before the IMF decided to include the renminbi in the SDR, the Chinese government announced that it was loosening its control over the currency. The PBOC declared that market signals would henceforth be factored into its daily exchange-rate fixing. And it promised gradual liberalization of China’s capital controls, which would boost the renminbi’s attractiveness to investors.

And yet the Chinese authorities’ latest move indicates that they have no intention of playing by the rules. Instead of further loosening its grip on the exchange rate, the PBOC is reasserting control and reducing the role of market sentiment in its decision-making.

The proof is in the pudding: the renminbi is clearly less freely usable than it was 18 months ago. Since mid-2016, China has been imposing strict new capital controls to prevent the renminbi from pouring out of the country and being converted into dollars. China has also placed new limits on Chinese corporations’ foreign direct investments, and it is scrutinizing other cross-border transactions.

It is not difficult to understand why China has reneged on its promises. Over the past two years, newly affluent Chinese citizens have been seeking ways to move their wealth abroad. This has increased downward pressure on the renminbi, and has forced the PBOC to spend more than $1 trillion in foreign-exchange reserves to prop up the exchange rate. And yet that still wasn’t enough to prevent Moody’s Investors Service from downgrading China’s credit rating earlier this month, leaving policymakers on the defensive.

Of course, China’s current problems may amount to a brief detour on the long road to greater openness. But they may not. If the Chinese government is serious about opening its capital market, it will have to implement reforms that go straight to the heart of the Chinese Communist Party’s model of political and economic management. An efficient, open financial sector could seriously erode the CCP’s authority, not least because financial repression is a key component in China’s machinery of political autocracy.

At best, China’s government acted prematurely when it insisted that the renminbi be included in the SDR. At worst, it set an unfortunate precedent that could encourage other big emerging economies, such as India or Russia, to demand the same treatment for their currencies, regardless of whether they meet the IMF’s criteria. Indeed, if China can get into such a prestigious, exclusive club despite its arbitrary policy behavior, then why can’t they? Never mind that the IMF’s authority would be severely compromised.

Looking to the future, there is only one solution. The renminbi should be removed from the SDR, unless China can make credible commitments to pursue serious and permanent financial liberalization. The criterion that a constitutive currency should be freely usable is a guarantee of stability for the global monetary system. That guarantee is only as credible as the criterion itself.