The International Monetary Fund’s decision to add the Yuan to its basket of Special Drawing Rights currencies honors the Chinese currency's ongoing internationalization. The Yuan will soon play a bigger role in Asia and in financial markets for development aid. But it will take much longer for it to become accepted as a reserve currency in private markets.
Several events this year mark China’s rise in international monetary affairs. On 26 January 2016, the International Monetary Fund (IMF) increased China’s voting share from 3.82 percent to 6.09 percent. On 1 October 2016, the Chinese Yuan (CNY) will become the fifth currency in the basket of the IMF’s basket of leading international currencies, which so far consists of the US Dollar (USD), the Euro, the Japanese Yen and the Pound Sterling. The average value of these currencies combined determines the value of the Special Drawing Rights (SDR).
The Yuan’s 10.9 percent share will come at the expense of the Euro, whose share will decline from 37.4 to 30.9 percent. Just like the voting rights reform, this change will lead to a more accurate reflection of both regions’ actual weight in the global economy. At the same time, it won’t mean that the Yuan has matured into a truly global currency – at least not in the world’s private financial markets. The IMF Board decision was a recognition of China’s currency as a gradually rising asset currency and as an important invoice currency in trade. It was not an insurance against ill-fated investment in CNY-denominated assets.
The SDR was created by the IMF in 1969 to supplement its member countries’ official reserves. The inclusion of the Yuan was the result of many years of discussion and evaluation. Over the years, due to China’s role as a leading export nation, the Yuan has become an important invoice currency in international trade. But to merit inclusion into the SDR, a currency has to serve other important functions. It needs to be used as a transaction currency, an asset currency and a reserve currency. In short, investors have to view it as a store of value. In November 2015, the IMF Board agreed that the Chinese Yuan can now be considered “widely used to make payments for international transactions” and “widely traded in the principal exchange markets.”
Why the Yuan is not a store of value
Yet, a closer reading of the Board decision reveals that its approval for the yuan as a global currency is still subject to qualifications. The IMF honors the process of Yuan internationalization rather than its final status. Unlike the Swiss Franc, the Norwegian Crown or the Australian Dollar, which are not in the SDR basket (as they are not important invoice currencies) but are freely usable, the Yuan can neither be used as a store of value for investors in government bonds, nor is it freely usable for portfolio or direct investors in China.
Capital imports into China or exports from China are still subject to restrictions. Chinese domestic financial markets are neither efficient nor competitive. Moreover, the exchange rate of the Yuan is not determined by the markets but remains pegged to a multiple currency basket whose composition is determined by the People’s Bank of China (PBOC). This method allows for more fluctuation than the US Dollar peg in the past, but the US dollar still has the largest weight in this basket. This makes the Yuan the only SDR basket currency that does not freely float against the other currencies. Therefore, it does not offer good options to hedge against exchange rate volatilities of the other four currencies.
So what difference will the inclusion of the Yuan in the IMF’s currency basket really make? The Chinese currency seems a long way from assuming a leading role as a reserve currency, let alone from challenging the Euro or the US Dollar. It is also unlikely to change the role of the SDR, which remains a unit of account and a mode of liquidity provision for the IMF. As long as financial markets in the US, Europe and Japan remain stable, open and liquid, central banks around the world will prefer to hold their reserves in one of the established leading currencies or in gold but neither in SDR nor CNY. For example, the SDR share of Germany’s exchange reserves is less than ten percent.
The RMB’s role is regional and market-specific
The Board decision helps Asian countries, which invoice their trade with China in CNY and/ or have swap arrangements with China as support in balance of payments crises. Under these arrangements, China offers stand-by loans to in CNY (for instance, through the Chiang Mai Initiative with ASEAN economies). In the past, it was a complicated process if recipients wanted use these loans to service international debts in other currencies (either creditors had to agree to accept CNY as payment or the PBOC had to convert CNY into other currencies). From now on, recipient countries can convert CNY into other currencies via the SDR, which greatly facilitates the use of Yuan to service international debt worldwide.
The Yuan’s inclusion in the SDR also has implications for the new international financial institutions powered by China such as the New Development Bank or the Asian Infrastructure Investment Bank. China will issue loans in CNY and the Board decision makes these loans more easily convertible into other currencies when investment would have to be paid in USD or European currencies. In short, the Board decision helps to avoid “tied aid” if CNY-denominated loans can only be used for contracts awarded to Chinese companies.
From the new international institutions, it is only a short way to changes in loan composition of the old institutions such as the World Bank. In August this year, the PBOC approved the World Bank’s inaugural issue in the Chinese domestic market of bonds denominated in SDR and payable in CNY. As in the past with loans for development aid issued in Japanese Yen (for instance, by the Asian Development Bank), public institutions as the World Bank act as icebreakers for promoting non-traditional currencies in asset markets.
Yet, these are very special markets protected by triple AAA ratings of these institutions’ state owners. The Yuan will take much longer to penetrate private financial markets. Before China can enjoy the benefits of issuing an asset currency, such being able to service debts in CNY or paying a lower risk premium on interest rates, it will have to create a stable, transparent, open and non-discriminatory environment for trade and capital flows.
The IMF has given a vote of confidence to the Yuan. It is now up to China’s authorities to do their homework and to prove that this confidence was not misplaced.