Does China's currency really belong in the SDR?
© Getty Images

When the International Monetary Fund (IMF) next revises its Special Drawing Right (SDR) basket in September 2016, China would very much like its currency to be included in that basket. Since that inclusion would confirm the Chinese renminbi's status as a major international reserve currency alongside the U.S. dollar, the euro, the Japanese yen and the British pound sterling. However, it is far from clear whether the Chinese currency is at present a "freely useable" currency as required by the IMF for SDR inclusion or whether it will become one by the time that the IMF completes its SDR basket review next year.

ADVERTISEMENT

Two considerations make it unlikely that the Chinese renminbi will qualify for inclusion in the SDR basket. The first is that while China's currency is being increasingly used abroad, China maintains an extensive system of capital controls that limits its convertibility. Not only does China severely restrict the ability of domestic residents to move funds abroad, but it also maintains an extensive control system on capital entering the country. That has to raise fundamental questions as to whether it is a freely useable currency.

The second consideration is that, in the wake of the bursting of its credit bubble and of the small August 2015 currency devaluation, the Chinese balance of payments has considerably weakened and is more than likely to continue to weaken in the months ahead. In this context, it has to be of concern that over the past 12 months, China has experienced massive capital outflows totaling some $500 billion. It also has to be of concern that the pace of those outflows has picked up markedly following the August devaluation.

Over the past five years, a striking feature of the Chinese economy has been the extraordinary pace at which corporate indebtedness has increased. Indeed, between 2008 and 2014, the overall indebtedness of the Chinese economy is estimated to have risen by some 90 percent of gross domestic product (GDP). That is approximately twice the pace of indebtedness that preceded the U.S. housing bust in 2006 or that preceded Japan's lost decade in the 1990s. This makes it more than likely that the marked slowing in the Chinese economy that is already very much in evidence will not prove to be a passing phenomenon. Rather, one must expect that as the Chinese credit bubble continues to burst, China's economic growth will remain under considerable pressure.

In the months ahead, Chinese policymakers must be expected to respond to the economy's slowdown by again trying to stimulate economic growth through both fiscal and monetary policy measures. However, to the extent that they reduce interest rates and they permit further currency depreciation, they will in effect reduce the attractiveness of holding the Chinese currency. That, in turn, is bound to add to the considerable pressures that are already in evidence on the Chinese capital account.

All of this makes it more than likely that in the year ahead China will not find itself in a position to create the conditions that will allow the Chinese currency to be included in the IMF's currency basket. In the context of a U.S. presidential election year, the Chinese will feel very constrained in how far they can allow greater room for market forces to determine the value of the currency. At the same time, as pressure on the Chinese capital account mounts in the context of declining domestic interest rates, the Chinese authorities will feel compelled to tighten their already restrictive system of capital controls. In so doing, it will be very difficult for them to make a persuasive case to the IMF that China has anything like a freely convertible currency.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.