News on the Special Drawing Right (SDR) of the International Monetary Fund (IMF) is generally relegated to the interests of IMF watchers. Nevertheless, the recent announcement of the IMF Executive Board’s conclusion of the SDR Valuation Review on May 14, 2022, attracted more attention.

Interestingly, SDR is neither a currency nor does it represent a claim on the IMF. In its present avatar, after the fall of the Bretton Woods system, SDR is an international reserve asset created by the IMF to “supplement the official reserves of its member countries”. Moreover, the composition of the SDR basket becomes vital as it “represents the relative importance of each of the currencies as a reserve asset”. The composition of SDR has been dynamic and has undergone revision every five years.

On November 30, 2015, the IMF’s Executive Board decided to include the Chinese RMB in the SDR basket as a fifth currency; with the US dollar, the Euro, the Japanese yen, and the British pound. Christine Lagarde, Managing Director of the IMF, stated, “The Executive Board’s decision to include the RMB in the SDR basket is an important milestone in the integration of the Chinese economy into the global financial system. It is also a recognition of the progress that the Chinese authorities have made in the past years in reforming China’s monetary and financial systems.” This was a welcome development for a currency that almost received the dubious distinction of a manipulated currency around 2005-06.

More recently, on May 14, the IMF announced an updated basket with new currency weights that will come into effect on August 1. Based on data for the five-year period 2017-21, the updated basket assigns higher weights for the US dollar and the Chinese RMB, while the weights for the British pound, the Euro, and the Japanese yen have been reduced (Table).

The RMB is now the third most important currency in the IMF’s SDR basket — next to the US dollar and the Euro. As the weights of currencies included in the basket should reflect their relative importance in the world’s trading and financial system, this is another testimony of China’s increasing importance in the global economy.

Weights of currencies

The weights of different currencies in the SDR basket are determined by a formula involving four factors for a currency. These are: (i) volume of exports in that currency; (ii) forex reserve holdings denominated in that currency; (iii) foreign exchange turnover of that currency; and (iv) sum of international banking liabilities and debt securities denominated in that currency. While 50 per cent weightage is given to the value of exports, each of the other three financial indicators gets a weightage of 1/6.

A breakup of these indicators shows some startling facts about the contrasting positions of China and the US in the real and financial sectors of the global economy. For the period 2017-21, rapid export expansion by China has ensured that exports in RMB have reached a staggering share of 22.3 per cent in global exports, which is just below US dollar and Euro denominated exports.

But for the financial indicators, China appears to be a much smaller player in the international economy. As the chart shows, only 2.2 percent of global forex reserves were kept in RMB for 2017-21, compared to 64.8 for the dollar. Similarly, for forex transactions and international banking liabilities and debt securities, the shares of RMB denominated transactions are significantly smaller than the comparable numbers for the dollar (Chart).

Why China’s influence is limited

This dichotomy between the real and financial variables highlights the paradox that despite the rise of China as the world’s top trading nation, its influence on the financial side has been limited. Why?

It is possible that China’s highly managed financial and exchange rate systems have not managed to enthuse much confidence among the other countries. Since the pandemic, increased government interventions and curbs on manufacturing and services sectors and a lack of transparency regarding data are not helping China’s cause either. While it can be argued that the US may have acted in many cases on similar lines, it still has the advantage of an incumbent.

To challenge the US as the possible global leader, China needs to significantly improve its image and position in international finance. Secondly, as the Chinese economy is slowing down and China is focussing more on its domestic economy, the RMB denominated exports may face some headwinds in the future.

Therefore, it could be entirely possible that the future rate of growth of the RMB in the SDR basket may not be as sharp as in the last decade.

Two key players

But for the present, the SDR allocation indicates that the US dollar and the Chinese RMB are emerging as the two key players in the global economy, but each with its strengths and weaknesses. While the RMB is becoming increasingly important in international trade in goods and services, the dollar continues to be the overwhelming favourite for global financial transactions.

The IMF acknowledges that in the future, there may be some disruptive impact on the relative roles of currencies due to developments in fintech, inflation, potential economic and financial fragmentation, sanctions, and others. But so far, their impact on the SDR composition has been minimal. For the near future, for all practical purposes, it could be a two-horse race with the US still ahead as the most important player in the global economy while China is trying to catch up.

Pal is a Professor of Economics at IIM Calcutta, and Ray is the Director of the National Institute of Bank Management, Pune. Views are personal

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