Membership in the elite reserve-currency club beckons, but it brings with it some obligations

Just when we were getting accustomed to China's stunning diplomatic success in bringing Europe and Asia together to launch the Asian Infrastructure Investment Bank, along comes another big test of China's position in the global pecking order.

Next month the International Monetary Fund in Washington will consider if there should be any changes in the composition of the Special Drawing Right, a synthetic currency the IMF created for issue to central banks. This review comes every five years, and although changes can be made within the five-year timeframe, it would be highly unusual to revisit the subject before 2020. The SDR is composed of dollars, euros, British pounds (sterling) and Japanese yen, with the dollar and euro making up 72 percent. The key issue that the IMF board will be considering is whether the Chinese currency should join the other four currencies as a global reserve currency. Although the IMF will not announce its final decision until October, by the end of next month an idea will be forming of the renminbi's chances this time.

Global reserve status means that a currency takes on a special position in the global financial markets as a store of value to investors, as a unit of measurement for multinational balance sheets and as a currency used in international trade. Investors would feel comfortable holding their assets in the currency, because they believe that value will be maintained, and their assets can be accessed cheaply and easily. So the currency has to offer a high degree of convenience and safety to international traders and investors. These characteristics in turn strengthen the currency's appeal to its own people.

The currency markets have long memories and are very conservative. The British pound ceased being the dominant currency in the world nearly a century ago, and the British economy is becoming less important globally year by year, but the pound is still one of the four global reserve currencies.

It is not easy for the renminbi to become a reserve currency. But if it happened, it would have major consequences for China's position in the world. The global equity index, called the Morgan Stanley Capital International Index, will include the Chinese onshore equity market, valued at about $9 trillion (8 trillion euros) which makes it the world's second-largest, after that of the United States. Chinese mainland's share of the global equity index would rise from about 2.5 percent to more than 10 percent. A large proportion of global equity investment is made through funds fixed to the MSCI index. Funds have to match index changes. With the MSCI index accounting for $48 trillion of global equity capital, index changes would bring several trillion dollars worth of investors' money into China, likely reducing Chinese interest rates.

Over the longer term, China's capital markets would become much more closely linked to the rest of the world. The Hong Kong-Shanghai Connect program, which started in November, and the Shanghai free trade zone have already started this process. The inclusion of the renminbi as a member of the SDR will accelerate it significantly.

In the decision published in the Third Plenum in November 2013, the government said clearly that market forces should play a "decisive" role in the Chinese economy. If China joins the SDR and becomes a reserve currency, then the renminbi's convertibility would have to increase. This means removing the approval process that presently controls outflows of capital. Large inflows of foreign capital and a more open currency would probably reduce Chinese interest rates and reduce currency risk for Chinese investing overseas. But greater openness would also weaken the control of the Chinese central bank over the domestic economy. The Chinese central bank could use interest rate policy either to influence the level of the renminbi or to speed up or slow down Chinese economic growth. But not both. Growth in China's economy is already affected by foreign demand for Chinese exports. Reducing capital controls will increase China's economic openness. Can the government promise economic stability to its people, while giving greater power to global market forces in the Chinese economy?

Yet China is already the world's second-largest economy, and by one important measure the largest. It is also the world's largest importer and exporter, the largest user of almost every commodity, the largest oil importer and the country with the most Internet users. China's global importance and interdependence is large and growing. Since China started to push the renminbi as a global currency in 2009 (as a response to the financial collapse of 2008 in the United States), renminbi swap agreements have been signed with 30 central banks, the renminbi has become the most important Asian trading currency, and more than 20 central banks, some in Europe, have arranged to hold renminbi as part of the reserves that back their own currencies. The renminbi has already become a reserve currency in the fastest-growing part of the global economy, Asia. Doesn't this mean that the renminbi is bound to join the SDR and become a global reserve currency?

One reason why not is economic. There is a strong argument that membership of the SDR will provide a strong external force for change and reform within China, as joining the World Trade Organization did in 2002. Chinese traditions impose obligations to respect international commitments. These obligations can outweigh the reluctance felt by many in China at making internal changes. But is China really ready to open its economy up to the swings and roundabouts of the global economic system?

Another reason why not is political. In March we saw the US try to isolate China by telling its key allies not to join the Asian Infrastructure Investment Bank. The growth of Chinese power in the Asia-Pacific region is an obvious challenge to the US, which is trying to maintain its strategic influence in a region that has become economically the most important in the world. The US may not be able to veto China's SDR membership, as a change in the IMF's constitution is not required, but it can exert strong influence against China joining the SDR.

Ultimately it is the market, not any government, that plays the key role in the rise of a currency, by choosing to use it to settle trades and to hold money deposits. The US, which often advises China to base its economy on market forces, should follow the market, take its own advice, and vote to bring the renminbi into the SDR. This would be a recognition of reality and would provide an important encouragement to the economic reform and change that China needs in order to meet the challenge of its slowing economy. Sometimes, as in 1999 when China decided to join the WTO, the correct course looks a little risky. But if China is to realize its dream, it must continue to trust itself, open up and embrace the world.

The author is a visiting professor at Guanghua School of Management, Peking University. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 05/15/2015 page10)