Chinese Yuan Becomes A Reserve Currency: What You Need To Know

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China has gotten the official nod from the International Monetary Fund (IMF) that it has long been waiting for. On Monday, that organization announced that China’s currency, the Yuan, will now become part of the IMF’s Special Drawing Rights (SDR) basket.

SDRs are a type of international currency, more or less, that is made up by a basket on international reserve currencies. In particular, the US Dollar, British Pound, Euro, and Japanese Yen were the old members of the basket.

Nothing got kicked out of the index to include the Yuan, however the percentage of the basket allocated to the Euro, Pound, and Yen was all reduced. The Dollar’s allocation was left virtually unchanged. The Yuan will now make up around 10% of the SDR.

In theory, being included in the SDR basket should boost the value of the Yuan. SDRs are used for a few specialty applications, for example, the cost of passing through the Suez Canal in Egypt is priced in SDRs.

However, in general, the SDR is not really used for much of anything. The IMF itself classifies the role of the SDR currently as “insignificant”. Some emerging markets borrow money in SDRs to a limited extent, but few major transactions occur using the instrument.

The SDR was originally created as the international monetary system began to move away from gold in the late 1960s. The SDR was designed as a gold alternative, a reserve asset less tied to any particular country or hard asset.

However, with the (relative) stability of the US Dollar, and the continuing widespread usage of gold as a reserve asset by both central banks and individuals, there has been little interest in adopting SDRs for their originally designed usage.

So the overwhelming effect of the IMF’s move to include the Yuan in the SDR is to boost China’s prestige, rather than any actual economic impact. The SDR, now consisting of just five currencies, is a rather exclusive club.

Other major international currencies, including the Swiss Franc, Canadian and Australian Dollars are all excluded from the basket while the Chinese are now in. Additionally, other emerging markets that strive to reach the next level, such as India, Brazil, and Mexico, are stuck on the outside looking in while China is able to secure prestigious reserve currency status.

Oddly enough, the most likely economic impact of the move will be, counter-intuitively, that the Yuan will weaken. You see, for China to get into the club, it had to take steps to liberalize its currency and pledge to let it float more freely.

China can still guide the Yuan’s exchange rate heavily, but it will have to spend far more money to do so. Previously, it could more or less set the exchange rate at whim every day, whereas now it will be based on the previous day’s closing price.

For the IMF to include the currency in the basked, it had to conclude that the Yuan is “freely usable”. This doesn’t seem to actually be the case at the time, but perhaps the IMF got assurances from China that things will keep moving that way.

If China is forced to let the Yuan actually float freely, the direction will almost assuredly be downward. The Chinese already devalued by several percent earlier this year, stunning international markets and triggering the sharp August equity selloff.

China’s international reserves, primarily dollars, have slumped from more than $4 trillion to under $3.5 trillion over the course of the year. $3.5 trillion is a ton of money by any measure, but $500 billion in outflows are nothing to sneeze at.

And the outflows almost surely would have been greater if China hadn’t locked down many flows of capital that were draining out of the country, such as halting the trading of hundreds of Chinese stocks.

China’s economy continues to sputter and slow, with various economic measures moving ominously downward. A devaluation would really help out China’s manufacturing engine, which has struggled as competition in Europe and Japan, benefiting from devaluations in those regions have shifted the competitive balance.

All in all, the IMF’s move won’t make a great deal of difference. And while China will certainly enjoy the boost in prestige, the actual economic effect will likely be to weaken the Chinese currency’s value.

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