China and the SDR: a storm in a basket

It is only a matter of time before China passes another milestone as the renminbi is added to the basket of currencies which determine the value of the IMF's special drawing right. However, analysts doubt that this will take place this year. What's more, when it does eventually happen, the practical significance both for China and for world markets will be far smaller than many believe. 

The IMF is due to conduct its five-yearly review of the special drawing right, or SDR, later this year. Two conditions must be met for a currency to be included in the SDR basket: the issuing country must have a large share of world exports and the currency must be "freely usable". China clearly meets the first condition, but it is debatable whether it meets the second. 

The key points are that the renminbi is not fully convertible and that China's currency and bond markets are small and are not yet completely open to foreign investors. On these grounds it seems to us that the renminbi is not yet ready for SDR "membership". That said, it is possible that political considerations will outweigh these arguments. China is eager to have its currency included in the basket and for that reason alone many governments may say "yes". 

"But whenever it happens, the implications would be modest. SDR "membership" is not necessary for a currency to become a reserve asset, as is demonstrated by the Swiss franc and indeed by gold. And while official holdings of renminbi is expected to increase - from almost zero - during the coming five to ten years, this is because China's financial markets are set to become gradually more open and liquid. It has nothing to do with SDR membership", said Capital Economics. 

Nor will expanding its basket lead to the SDR playing a bigger role in global finance. The positions of the dollar and euro as the world's first and second reserve currencies look secure. The SDR is not an attractive reserve currency because it has very limited uses: there is no SDR bond market and the supply of SDRs is small. Moreover, it is easier for investors to hold its constituent currencies than the SDR itself. Adding the renminbi to the SDR basket would probably make it less attractive. 

Finally, changes to the SDR basket currencies will make no difference to China's role in the governance of the IMF or other international organisations. Decisions at the IMF are mostly determined by political consensus, and occasionally by votes in the Executive Board. These are unrelated to the rather obscure question of how the SDR is defined.