“The International Monetary Fund on Monday admitted China’s yuan into its benchmark currency basket in a victory for Beijing’s campaign for recognition as a global economic power. The IMF executive board’s decision to add the yuan, also known as the renminbi, to the Special Drawing Rights (SDR) basket alongside the dollar, euro, pound sterling and yen, is an important milestone in China’s integration into the global financial system and a nod to the progress it has made with reforms.
To meet the IMF’s criteria, Beijing has undertaken a flurry of reforms in recent months, including better access for foreigners to Chinese currency markets, more frequent debt issuance and expanded yuan trading hours. The currency will have a 10.92 percent share, in line with expectations, after a review of the weightings formula for the SDR, which determines which currencies countries can receive as part of IMF loans.
The yuan’s inclusion is a largely symbolic move, with few immediate implications for financial markets. But it is the first time an additional currency has been added to the SDR basket and the biggest change in its composition in 35 years. Last set in 2010, the basket is currently 41.9 percent dollar, 37.4 percent euro, 11.3 percent sterling and 9.4 percent yen.
The yuan СNH=CNY would not join until October 2016, allowing reserve managers time to prepare. Under the new formula, the euro’s share will drop to 30.93 percent. Sterling and yen will also have lower weights while the dollar remains about the same.
To be included in the SDR basket, the yuan had to meet the criteria to be “freely usable,” or widely used to make international payments and widely traded in foreign exchange markets – a yardstick it missed at the last review in 2010. The addition is likely to fuel demand for China’s currency and for renminbi-denominated assets as central banks and foreign fund managers adjust their portfolios to reflect the yuan’s new status. Currency analysts estimate the IMF seal of approval could fuel demand worth more than $500 billion in coming years and take the yuan’s share of global reserve holdings to around 5 percent, overtaking the Canadian and Australian dollars.
In a factsheet accompanying the decision, the IMF said that since Chinese interest rates were higher than those of other currencies, it was likely that the SDR interest rate would rise as a result of the yuan’s inclusion.
What is the special drawing rights system?
The special drawing rights (SDR) system was created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system. As the IMF explains: “A country participating in this system [Bretton Woods] needed official reserves – government or central bank holdings of gold and widely accepted foreign currencies – that could be used to purchase the domestic currency in foreign exchange markets, as required to maintain its exchange rate.
“But the international supply of two key reserve assets – gold and the US dollar – proved inadequate for supporting the expansion of world trade and financial development that was taking place. Therefore, the international community decided to create a new international reserve asset under the auspices of the IMF.”
Not long after the creation of the SDR, the Bretton Woods system collapsed and the major currencies shifted to a floating exchange rate regime. But the SDR system has become more important again recently by supplementing member countries’ official reserves during the credit crunch and global financial crisis.
So is the SDR a currency?
No. The SDR is instead an international reserve asset which the IMF uses to supplement its member countries’ reserves. The SDR’s value is based on the basket of the four international currencies and SDRs can be exchanged for “freely usable” currencies, the IMF says. SDRs are allocated to IMF members from time to time. From October next year, once the yuan is added, the basket will have five currencies.
Nor is the SDR a claim on the IMF, rather it is a “potential claim on the freely usable currencies of IMF members”, the IMF says. Holders of SDRs can obtain those currencies in exchange for their SDRs. They can either arrange exchanges between members or the IMF can designate members with strong external positions – those with big current account surpluses – to purchase SDRs from members with weak external positions.
How do currencies get added to the SDR basket?
The SDR basket, upon which the SDR’s value is based, is typically reviewed every five years by the IMF’s executive board to ensure that it “reflects the relative importance of currencies in the global trading and financial systems”.
The weighting of different currencies can shift at these reviews and it is also an opportunity to add new currencies. The last time that happened was in 1999 when the newly created euro single currency was added, although technically it replaced the outgoing German deutschmark and French franc.
What criteria must currencies meet to join the basket?
The basket is based on currencies from the four countries or currency unions – such as the eurozone – whose exports of goods and services had the largest value over a five-year period. Once China’s yuan is added, that list of currency issuers expands from four to five. To join the basket, a currency must also be judged by the IMF’s executive board to be “a freely usable currency”. In other words, it must be a currency that is widely used to make payments for international transactions and widely traded in the main exchange markets. There is also an “export criterion”, designed to ensure that currencies in the basket are those issued by IMF members or currency unions that “play a central role in the global economy”, in the IMF’s words.
Chinese authorities have announced a series of changes to liberalise the country’s financial markets, moves seen as also helping the yuan meet the freely usable rule. In particular, Beijing surprise devaluation of the yuan this year was seen as a move towards allowing the market, instead of the government, to fix the the currency’s value, thereby easing the way to SDR inclusion.”
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