What you need to know about China’s inclusion in IMF currency basket

IMF’s big decision won’t have much impact outside of China

“It’s not like the SDR is the MSCI world index, where if a company is included, a bunch of portfolio managers need to go out and buy it,” 

 

The International Monetary Fund’s executive board on Monday decided to include the Chinese yuan—also known as the renminbi—in its Special Drawing Rights basket. The decision was widely expected after the organization’s staff recommended inclusion a few weeks ago.

But the significance of this decision is still unclear to many, partly due to the complexity of the forces that government international reserves, and partly because the SDR’s role in the global economy isn’t widely understood.

See: Euro to see biggest drop in IMF basket to make way for the yuan.
Here’s what you need to know about the yuan, the SDR and the potential fallout of Monday’s decision:

What’s an SDR good for?
Special Drawing Rights are an artificial reserve asset created for central banks in the late 1960s, and as such, they’re largely a relic of the Bretton Woods era.

When first introduced, SDRs were meant to rectify a shortage of two important international reserve assets: gold and the U.S. dollar. But its usefulness was greatly diminished by the fall of Bretton Woods, and the increasing availability of credit through international financial institutions.

Central banks don’t use the SDR as a yardstick for determining the composition of their foreign-currency reserves. These are much more heavily influenced by cross-border trade, said Karthik Sankaran, a director of global strategy at Eurasia Group.

An analysis of the most recent IMF data on central-bank reserves shows that the dollar comprises a much larger percentage of global central-bank reserves than its SDR weighting would suggest. The SDR weightings are set every day by the IMF.

Here’s blogger Macro Man’s side-by-side comparison of SDR weightings versus reserve holdings by central banks, as represented by COFER, or composition of official foreign exchange:

COFER              SDR
USD 63.74%    48.05%
EUR 20.49%   32.60%
GBP 4.68%     12.17%
JPY 3.83%      7.18%
Will this lead to a surge in demand for the yuan?
Central banks have already started to accumulate yuan reserves to reflect China’s dominant role in cross-border trade—but this has been limited by continued Chinese government controls over the currency and yuan-denominated debt.

So most currency strategists believe the yuan’s inclusion in the SDR basket won’t significantly increase central-bank demand for yuan. Actually, the decision has little real significance outside of China.

“It’s not like the SDR is the MSCI world index, where if a company is included, a bunch of portfolio managers need to go out and buy it,” said Greg Anderson, global head of currency strategy at BMO Capital Markets. “This is about prestige, really.”

Will the yuan dethrone ‘king dollar’?
The yuan’s inclusion in the SDR basket will bolster its reputation as a global reserve currency. But regardless of Monday’s decision, it’s far from challenging the dollar’s roll as the world’s premier reserve currency.

The yuan is only the fifth most-used currency for settling international payments, according to the Society for Worldwide Interbank Financial Telecommunication, or SWIFT, which tracks the yuan. Only a fraction of global central-bank reserves are denominated in yuan.

This will likely change as China lifts its controls on the currency’s valuation and usage. In August, policy makers abruptly shifted their methodology for setting the onshore yuan’s daily reference rate to a more markets-based approach, which led to a sharp depreciation in the currency. Though many restrictions on capital flows remain, policy makers have begun to unwind some of these restrictions.

Daragh Maher, U.S. head of currency strategy at HSBC, believes that as China opens its economy and capital account, the share of international reserves denominated in yuan will continue to grow. But he said he couldn’t envision the Chinese currency supplanting the dollar any time soon.

“It will be a diversification currency alongside sterling and the yen,” he said.

Will China stick with reforms?
Chinese policy makers have repeatedly assured the world that they plan to slowly relinquish control over the yuan. Measures to open markets over the past year have apparently been sufficient to allow the currency to meet the IMF’s definition of “freely usable”—a requirement for inclusion in the SDR.

But now that China has achieved its goal of SDR inclusion, many market strategists—and U.S. policy makers—are worried that China will reverse course.

But Sankaran believes China will continue with gradual liberalization, because it’s in their interest to do so. The country has a large stock of private savings that is currently largely invested either in domestic equities or real estate, creating problems with overvaluation. Broadening the palette of investment options makes sense, provided this is done through institutional channels, limiting the risk of individual flight.

How does the U.S. feel about this?
Over the past two decades, U.S. lawmakers have often accused China of manipulating its currency to keep it artificially weak, making the country’s exports more competitive and contributing to the country’s rapid growth.

Back in the spring, Treasury Secretary Jacob Lew said he believed the yuan was unfit for inclusion in the SDR, saying the country needed to further ease restrictions in its currency to meet the criteria of “freely usable.”

Now that the yuan has been admitted, the U.S. looks silly for ever opposing this, Anderson said.

And that embarrassment could grow if the yuan continues to weaken as its exposed to more market forces.

“One of the ironies is that U.S. is going to want [China] to intervene more, not less, going forward,” Sankaran said.

http://www.marketwatch.com/story/what-you-need-to-know-about-chinas-inclusion-in-imf-currency-basket-2015-11-30

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