China’s gold star

If your elementary school was like mine, when you did a good job on your homework you got it back with a gold star pasted on top. The gold star was not valuable itself—you couldn’t deposit it in the bank—but it recognized your good efforts and, maybe, motivated you to work hard on the next assignment.

China received the equivalent of a gold star this week, when the International Monetary Fund agreed to include the Chinese currency, the renminbi, as part of an IMF-managed asset called the Special Drawing Right, or SDR. Like the awarding of a gold star, inclusion in the SDR is almost entirely symbolic. SDRs, which are defined by the IMF as a fixed combination of the dollar, the euro, the British pound, the yen, and now the renminbi, were created in 1969 to provide an alternative medium for governments and central banks to hold international reserves. However, in practice they are not much used, except for internal accounting within the IMF, and the renminbi’s inclusion in the SDR confers no meaningful additional powers or privileges on China.

If SDR inclusion is only symbolic, then what’s the big deal about the IMF’s decision? Well, the Chinese authorities, who very much want their country to be recognized as a global economic power, care a lot about symbolism. And SDR inclusion does recognize both the increasing economic power of China and the important steps the Chinese have taken over the years to open up their capital markets, to meet international norms in financial regulation, and to increase the extent to which market forces help determine the renminbi’s value. Recognizing China’s progress in these areas, and encouraging more progress, are reasonable steps for the IMF and the global community to take. 

SDR inclusion does not mean, however, that the renminbi will rival the dollar as an international currency, at least not any time soon. The dollar is widely used globally in trade, in international borrowing and lending, and as the principal currency for official reserve holdings (about sixty percent of global reserves are held in dollars). Importantly, the dollar’s global status is a market outcome, not the result of a decision by any international body or of an international agreement. Private investors and governments freely choose to hold dollars because the markets for dollar-denominated assets are, by far, the deepest and most liquid of any currency; because the United States imposes no restrictions on capital flows in or out of the country; because of the quality of U.S. financial regulation; because the Federal Reserve has kept inflation low and stable for the past thirty years; and because the United States is large, prosperous, and politically stable.

If China continues to develop economically and to liberalize its institutions, then someday the renminbi may play a larger role in international trade and finance than it does today. Is that something we should worry about? The underappreciated fact is that the direct benefits to the United States of issuing the dominant international currency are probably quite modest. It’s often argued, for example, that the dollar’s status allows the United States to borrow abroad more cheaply; but, in inflation-adjusted terms, the U.S. government does not enjoy meaningfully lower borrowing costs than other advanced industrial countries. We do benefit from the fact that much U.S. currency is held abroad, since these holdings amount to interest-free loans to our government; but other currencies, like the euro, are also widely held, and in any case the interest savings from foreign currency holdings are tiny compared to the overall U.S. government budget or the size of our economy. Rather, like the gold star on your homework, the dollar’s status is valuable only insofar as it is symbolic of the underlying strengths of the U.S. economy. 

So, we should care about currency status, but primarily because of what it represents, not because of its direct advantages. In particular, if in coming decades the renminbi’s global role grows for “good” reasons, like continuing liberalization and deepening of Chinese capital markets—as opposed to “bad” reasons, like a deterioration of liquidity in U.S. markets—then that growth will be positive for the U.S. and the global economy, as well as for China.

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