Will devaluation help make the renminbi a reserve currency?

Earlier this month, global financial markets nearly imploded. From East Asia to Western Europe, currencies swooned and equity prices tumbled – all because of China’s decision to allow a modest devaluation of its currency, the renminbi. China’s economy is on the brink of collapse, pessimists warned. A new era of currency wars is about to be unleashed, doomsayers chimed in. To call this an overreaction would be a gross understatement.

Admittedly, the Chinese economy has been slowing, not least because of a sharp decline in the country’s exports. And devaluation of the renminbi could be viewed as an aggressive move to reverse the export slide and restore domestic growth – a move that could prompt competitors in Asia and elsewhere to push down their exchange rates as well, triggering an all-out currency war. So, in this regard, investor fears were not without merit.

But how serious was the threat? In reality, China’s devaluation was puny – by the end of the week, less than 5% in all. Compare that to the euro’s 20% drop so far this year, or the yen’s 35% dive since Japan embarked on its “Abenomics” reform program in late 2012, and it is clear that overblown headlines about the renminbi’s “plunge” were woefully misleading. Had China really wanted to grab a bigger share of world exports, it is hard to imagine that its policymakers would have settled for such a modest adjustment.

China’s real motivation seems to be more far-sighted. The devaluation advanced China’s strategic goal of turning the renminbi into an international reserve currency – and, in the long term, into a credible global challenger to the US dollar.

To this end, China has been campaigning for years to have the renminbi added to the basket of currencies that determines the value of the Special Drawing Right (SDR), the International Monetary Fund’s synthetic reserve asset. As it stands, that basket includes the US dollar, the British pound, the euro, and the Japanese yen. If the renminbi were added to this group of the world’s leading currencies, it would gain considerable prestige, and central banks would undoubtedly increase their use of the currency as a reserve asset.

According to the IMF, for a currency to be included in the SDR basket, it must meet two key criteria. The first – that the issuing country must be among the world’s leading exporters – is not an issue: China already is the world’s largest exporter.

But the second criterion – that the currency must be “freely usable” (widely used and widely traded) – has proved to be a major stumbling block. Given tight government-imposed limits on foreign investors’ renminbi purchases, as well as Chinese investors’ use of renminbi to invest abroad, not many observers would describe the currency as freely usable. Indeed, just a couple of weeks ago, an IMF staff report concluded for precisely that reason, the renminbi was not yet ready for prime time in the global economy.

But China has been taking concerted steps to expand the use of the renminbi, including signing swap agreements with more than two dozen countries, actively encouraging offshore markets for renminbi deposits and bonds, and moving cautiously to open domestic capital markets.

China currently is addressing another key factor holding back international use of the renminbi: government control over the exchange rate. The renminbi’s exchange rate has historically been fixed daily by the People’s Bank of China (PBOC), without regard to underlying market sentiment, and allowed to trade within very narrow limits. But China has now announced that market signals will henceforth guide its daily exchange-rate fixing. Assuming the PBOC follows through, China can more credibly claim that its currency is freely usable – or at least that it is moving in that direction.

Of course, not everyone is convinced yet. We must wait to see how the PBOC behaves in practice. But the IMF has certainly noticed, suggesting that “a more market-determined exchange rate would facilitate SDR operations, in case the renminbi were included in the currency basket going forward.” That is quite a shift in tone from the earlier staff report.

While much of the world was distracted by the putative threat of currency wars, China may have found a way to sneak its way into the SDR basket. At least for now, it seems that the country’s long-term strategy for the renminbi is on track.

This article is published in collaboration with Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Benjamin J. Cohen is Professor of International Political Economy at the University of California, Santa Barbara, and is the author of Currency Power: Understanding Monetary Rivalry.