An honour for the yuan

Macro Highlights - 10/5/2016

The yuan will now be among the currencies in the IMF's Special Drawing Rights basket, an encouraging sign of China’s ongoing integration in the global financial system. Trust in the yuan will take time to build. In the short term, the Chinese currency should remain under pressure.

On 1 October, the yuan will join the elite group of currencies that make up the International Monetary Fund's Special Drawing Rights, something that the Chinese government has been looking forward to for a long time. This move marks China’s latest step towards greater integration in the global financial system, although it is unlikely to be accompanied by a significant appreciation of the yuan.

The IMF’s Special Drawing Rights (SDR) are international reserve assets that supplement IMF member countries’ official currency reserves. If member countries need to modify the composition of their currency reserves, they can sell SDRs to other member countries in exchange for the currencies in the basket. These instruments proved useful in 2009 during the financial crisis, when they helped restore global liquidity and supplemented member countries’ official currency reserves.

The value of an SDR is set daily on the basis of a basket of currencies whose individual weighting depends on the extent of their use in commercial and financial transactions. This basket is composed of the US dollar, the euro, the yen and the pound sterling – and now the yuan, with a weighting of 11% (see left-hand chart).

A Special Drawing Right is not a currency but rather a virtual claim on the currencies that make up the underlying basket. The inclusion of the yuan will affect how the value of the SDR and related interest rates are calculated, but it does not mean that central banks will be forced to increase their yuan-denominated reserves.

The yuan is not currently considered a reserve currency, unlike the Swiss franc and the Canadian dollar, which represent a small fraction of central banks’ international currency reserves although they are not part of the IMF’s SDR basket (see right-hand chart). A total of USD 285 billion worth of SDRs have been allocated to member countries, which is a small amount compared to the USD 11,413 billion currently held in official currency reserves (see left-hand chart below). Given the amounts at stake, inclusion in the SDR basket is a largely honorary distinction, and the real challenge for Beijing now is to have the yuan adopted as a reserve currency. That will make Chinese financial assets very attractive to central banks and international investors, who hold little of these assets (only around 1-2% of domestic financial assets).

But achieving the status of reserve currency will take a long time. The yuan will first have to win the trust of international central banks. It will depend on other factors too, such as the yuan’s upside and liquidity, the growth and depth of domestic asset markets, the Chinese economy’s openness to foreign capital and the credibility of the People’s Bank of China.

Investors and central banks cannot ignore a number of unhealthy signs: capital controls aimed at easing downward pressure on the yuan, capital flight and the Chinese government’s intervention during the 2015 stock market crash (topped off by the suspended trading of numerous shares).

Inclusion in the SDR basket is clearly a step forward in terms of China’s integration in the global financial system. That said, short-term dynamics like slowing domestic GDP growth and the strengthening US dollar are likely to push the yuan slightly downward (see the Macro Highlights of 20 June). The yuan’s presence in this basket could even exacerbate this currency’s short-term volatility, since the People’s Bank of China will have less incentive to prop up its value (see right-hand chart).

The yuan’s elevated status represents international recognition of China as a key economic and financial player, but it raises questions about the openness of the country’s capital account and about the development of its financial markets. The effort to win international credibility for the yuan really starts now.

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