By Krishna Koundinya Mothukuru
SDRs (Special Drawing Rights) are again making the news, because the IMF has allowed staff to include the Chinese Yuan in the SDR Reserve Currency basket. Needless to say, this is a huge victory for Beijing. It comes at a time when doubts are being cast over the health of Chinese economy. China, being the 2nd largest economy in the world, definitely deserves to be in the basket of the world’s most trusted currencies.
SDR currencies are foreign exchange reserve currency assets created by the IMF. Technically, they are not currencies, they signify the right of the holding party to obtain any currency from the underlying basket of currencies. Presently, it is composed of US Dollars ($-41.9%), Euro (€-37.4%), Pound Sterling (£-11.35) and Japanese Yen (¥-9.4%)1.
The primary objective is to help economies with huge external economic liabilities by tiding over financial storms with help from economies with more cash. Entry into SDR signifies the confidence world economic markets have in that particular currency. This coming of age of the Yuan is not entirely unexpected in light of a slew of economic reforms undertaken by China in the recent past to tick off the IMF checklist. It scrapped a ceiling on deposit rates, increased the transparency of economic data, issued Treasury bills, and proposed to extend trading hours to overlap with Europe2.
There are two important criteria for inclusion of a currency into SDR. One, the nation whose currency is to be included should be a major exporter of goods and services, and two, the currency in question must be freely usable.
Nobody today questions the eligibility on Yuan on the first criterion. Chinese exports are ahead of Japan and Britain, whose currencies are included in the SDR basket. But, it is not clear if the Yuan meets the second criterion due to various interpretations of the phrase ‘freely usable’. If it is construed as ‘fully convertible’, then, like the Rupee, the Yuan is not fully convertible. In fact, China puts caps on repatriations, prescribes quotas for foreign investments in capital markets, etc. If the phrase is interpreted as ‘widely used in international transactions and widely traded in global markets’, then the Yuan certainly meets the bill, and the IMF leans to the latter.
While most of the analysts have concentrated on why Yuan is to be included into the SDR, what has not got any attention is the timing of this inclusion. It does cast some questions which need to be answered.
The IMF uses certain benchmarks or indicators to determine the second criterion. It has a five year review of the basket of currencies; the last review was in 2010, when the Yuan was judged not to meet the ‘freely usable’ criterion. This August, the IMF admitted that the Yuan was trailing many global counterparts in major benchmarks3 like currency trading, debt holdings, etc. Counterintuitively, even after the IMF’s apparent inclination, the Yuan has actually depreciated4.
China has devalued the Yuan, triggering a fear of beggar-thy-neighbour currency wars. Though this is not a big threat at present, it does not assuage the fear of ‘artificial’ devaluation of Yuan to keep its goods competitive in the near future.
Parallels can be drawn with Japan, which also has a dark record in exchange rate manipulation. In the 1980s, Japan artificially lowered the Yen to hit 220-a-dollar and flooded the US auto market with Japanese-made cars. This nearly killed the American auto industry and induced intervention by Washington in the form of import quotas.
China is in a very similar position today – it is the same strategy of flooding foreign markets with cheap goods by manipulating the exchange rates. The US was rather vocal about it demand of letting the Yuan appreciate as per the free market principle, but it had been for naught.
This line of thought triggers another set of questions. If the Yuan is not strong enough, why is the IMF proactive about it? Does the West stand to gain by such an inclusion? Is it just based on benevolence of IMF or the pure merit of the Yuan? Are there any ulterior motives?
Though the US is trying to contain China with its Asia Pivot policy, it is still dependent on China for cheap goods. Given the huge For-Ex war chest China has built up over the years, there is always a credible threat of dumping dollars in the international market and destabilising the currency, especially when the US economy is still in the doldrums.
The US will have to make costly compromises to maintain its hegemony in a world of rising Asian powers and their demands for reforms in the Bretton Woods dominated economic order. By including the Yuan in SDR, it can compel a ‘closed’ Chinese economy to ‘liberalise’ and force the Yuan to appreciate, thereby killing two birds with one shot.
It is the Board of Directors which takes the final decision, and it neither needs consensus nor does it need empirical evidence to back its decision. Given the domination of the US on the Board, it can manipulate the IMF to suit its goals, and the timing of such a decision seems to suggest it is doing precisely this.
Closer to home, however, India too may stand to gain from entry of the Yuan into the SDR. Chief Economic Advisor Arvind Subrahmanyam recently opined that India should support the Yuan’s claims5 because it will force the Chinese economy to liberalise and internationalise, thus deterring Chinese exchange rate manipulation. Once the Rupee depreciates with respect to the Yuan, India will be seen as a viable alternative for foreign investment. Given a higher growth rate than China, recent commendable performance in the Ease of Doing Business Index, and new initiatives like ‘Make in India’, India will, at large, gain from the Yuan’s entry into the big leagues.
The author is an entrepreneur who has worked with companies like Deloitte and RINL, and has assisted CXOs with financial valuations, IPO estimates, etc.