In the short term, the Fed’s rate hikes will unleash another period of crises across the emerging and developing world. In the medium term, the expected addition of the Chinese renminbi in the IMF’s basket will open up the world’s currency reserves to emerging economies.
A half month ago, the International Monetary Fund (IMF)’s staff and its chief Christine Lagarde supported the inclusion of China’s renminbi (RMB) in the IMF’s elite basket of major international reserve currencies. Currently, the latter includes only four advanced-economy currencies: US dollar, the euro, British pound and the Japanese yen.
If the IMF’s endorsement is approved at its Board meeting on November 30, it would mark the most critical change to the “Special Drawing Rights” (SDR) basket since its creation almost half a century ago. If not, the inclusion would likely take place in another vote next year or soon thereafter.
Not so long ago, the IMF was still skeptical about the RMB inclusion. Why did the organization change its mind? How will the RMB inclusion impact capital inflows to RMB assets? What will be the short-term currency impact? And what does this all mean vis-à-vis emerging economies?
Why RMB should be added to the IMF basket
While critics like to think that Chinese lobbying changed the IMF’s mind, the reality is that the IMF’s rules necessitated the inclusion of the RMB.
For all practical purposes, the IMF review consists of two steps. The first requires that the currency economy is a major trading nation. Well, China is the world’s largest exporter and second-largest importer, right after the US.
Another technical requirement is for the RMB to be “freely usable.” Despite accelerated reforms, capital account restrictions do remain in China. Critics claim that Chinese currency is not freely usable because it is not fully convertible. However, the latter is not necessarily required by the IMF.
Indeed, the Japanese yen was seen as freely usable already in 1978, two years before Tokyo eliminated its foreign exchange controls. In turn, China seeks managed convertibility, not full capital account liberalization – which should fulfill the IMF requirements.
The second step of the IMF Review requires a final vote by the IMF Board. That is the political part of the procedure and the RMB needs a 70 percent majority to become a reserve currency.
Today, the RMB is supported by the IMF staff, including its chief, the largest European economies and (conditionally) by the US.
The expected inclusion impact on capital inflows into RMB assets
Nevertheless, critics argue that the RMB inclusion would not provide a significant boost to the currency’s internationalization. They claim that the gains would be at best $40 billion in the next few years; just a drop in the more than $10 trillion of global reserves.
For all practical purposes, these critics mistake the impending shifts in the IMF basket with the expected total capital inflows into RMB assets. The latter are likely to include three waves of capital unleashed by first the re-weighting of the IMF basket and followed by those of public and private investors.
Take first the initial re-weighting of the IMF elite basket. Currently, it is valued at $280 billion and remains currently dominated by the US dollar and the euro, which together account for four-fifths of the total. If the RMB’s initial weight would be the anticipated 10-14 percent, it would be prudent to expect a shift of $50 billion in the RMB assets starting between 2016 and 2020.
Next, public investors – central banks, reserve managers, sovereign wealth funds – would be likely to follow suit. If China’s current share of global reserves is around 1 percent and the IMF decision could trigger another 4 percent, that would translate to some $350 billion in RMB assets by 2020.
Finally, private institutional and individual investors are expected to follow in the footprints. If their allocations would rise to just 1 percent in the next half a decade, it would add $200 billion into RMB assets by 2020.
Moreover, these estimates could prove conservative. China’s current share of global reserves may be higher than estimated. Moreover, total foreign exchange reserves also include some $5.7 trillion unallocated reserves. Third, after half a decade of stagnation in the major advanced economies, all investors are struggling to gain higher yields and to diversify their assets – hence their interest in the RMB option.
US dollar will strengthen – but not forever
What impact would these shifts have on the RMB’s expected exchange rate? After all, since fall 2014, the Fed’s expected rate hikes has contributed to a strengthening US dollar.
At year-end 2013, the US dollar was still RMB 6.05. After the plunge of the oil prices, the slow recovery of the US economy and the Fed’s impending rate hikes – and the accelerated liberalization of the Chinese capital account and exchange rate – US dollar is today about RMB 6.40.
By the end of 2016, the consensus view expects the dollar to further strengthen to about RMB 6.50 or more. Nevertheless, in the medium and long term, the renminbi will strengthen vis-à-vis the US dollar.
What about the naira? At the year-end of 2013, US dollar was still about N160. However, as the forces of depreciation have pressured the Nigerian currency for two long years, US dollar has strengthened some 25 percent to N200 officially; and significantly more in the black market. At the same time, the Chinese renminbi has strengthened from N26.50 to about N31.20, or about 18 percent.
Next year, the Nigerian naira is likely to erode further because of the US Federal Reserve’s impending rate hikes, which will strengthen the dollar. In the long term, the Chinese currency will strengthen as the re-weighting of the IMF basket will pave way for capital inflows by public and private investors into RMB assets by 2020 and thereafter.
In the short term, however, as the Fed hikes are expected to begin, most emerging markets will take heavy hits, particularly those economies that have dollar-denominated debt, diminished growth prospects and plunging oil revenues.
The recent decision by South Africa’s central bank to raise interest rates to protect its battered currency precipitates what’s yet to come across Africa. In still other countries, the anticipated emerging-economy turmoil is likely to reinforce demands for faster “de-dollarization.”
IMF’s reserve currencies represent advanced, not emerging economies
When the old Bretton Woods system and the associated dollar hegemony evolved after World War II, the US economy accounted for almost half of the world GDP. Today, its share is a fifth. Unlike then, US economy also suffers from twin deficits, secular stagnation and a debt burden that exceeds the size of the real economy.
Meanwhile, China, which still dominates a third of global growth, has no role in the IMF basket. Instead, that elite basket has been dominated by US dollar (42 percent), the euro (38 percent), UK pound (11 percent) and Japanese yen (9 percent) – even though they no longer fuel the world economy.
What about public investors? Here, the status quo is even worse. Before the global crisis, advanced economies dominated most global reserves. Today, that role belongs to emerging economies. Nevertheless, US dollar (62 percent), the euro (20 percent) and other advanced-economy currencies dominate a whopping 96 percent of the allocated foreign exchange reserves.
In light of these realities, the economic reasons for including the RMB in the IMF basket are compelling, while the risks of not doing so are becoming overwhelming. It will be the first – hopefully not the last – emerging-economy currency to be included in the IMF basket.
It is time for the world’s currencies to look (just a bit) more like the people that our multilateral financial organizations claim to represent. Meanwhile, it is best to buckle up as the Fed’s rate hikes will unleash another period of economic uncertainty and market volatility across the emerging and developing world.
Dan Steinbock
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