It’s a big day for China. The International Monetary Fund just welcomed China's yuan into its benchmark currency basket, a major victory for Beijing's campaign for recognition as a global economic power.
The IMF made the decision after evaluating China’s position as an exporter and the yuan's role as a "freely usable" currency. According to IMF Managing Director Christine Lagarde, “The yuan's inclusion is a clear representation of the reforms taking place in China.”
The addition of the yuan, also referred to as the renminbi, is scheduled to take effect next October and it will join the euro, yen, pound and dollar in the Special Drawing Rights (SDR) where it will have a weight of about 11 percent of the total SDR basket. It is this basket that determines the currency mix disbursed in financial aid by the IMF to its members.
The IMF is certain that the inclusion of the yuan will result in an increased demand for the currency and will act as a catalyst for China’s future economic development.
The International Monetary Fund just welcomed China's yuan into its benchmark currency basket, a major victory for Beijing's campaign for recognition as a global economic power.
What exactly is this currency basket and why is it important?
The SDR is a type of international reserve benefit created in 1969 by the IMF to bolster the system of fixed exchange rates that was established in Bretton Woods at the end of World War II. Up until that time, most countries were able to use major currencies and gold holdings in exchange for their local currencies overseas in order to maintain their exchange rates. When the supply of gold and the dollar started lagging and could not keep pace with the growth in world trade or new developments in financial markets, the IMF created an asset that could be exchanged for freely usable currencies.
The SDR is not a currency or a claim on the IMF. Rather, holders of SDRs can exchange them for currencies that make up the basket through deals with other SDR holders. As part of the original arrangement, countries were allotted SDRs in proportion to the IMF quotas they pay. They were able to use SDRs to rebalance their reserves, make payments for future quota increases or to settle debts they owe to the IMF.
SDRs have been used by various countries for over 45 years. Since the Bretton Woods system collapsed in 1973, however, countries have turned to SDRs less frequently. Instead, they have allowed their currencies to move more freely in line with market forces and although the benefits of using SDRs remain, they have lost much of their luster. They last time SDRs proved their worth was during the global financial crisis when they helped supplement member countries' official reserves.
As of September 2015, $204.1 billion of SDRs has been generated and allocated to IMF's members. This number is equivalent to about $280 billion. The admission of the yuan to the currency basket is seen as the biggest change to the basket since 1999 when the euro was introduced. For those central banks that use their foreign currencies reserves to buy their own currency or pay international debts, the inclusion of the yuan would mean they now have an additional alternative besides dollars and euros in which to hold their foreign exchange reserves. This would help many emerging markets who already have strong trade linkages with China.
The People's Bank of China was pleased with the move which was backed by countries including the United States, Britain and Japan, as it indicated that the international community expected China to play a bigger role in the world economy. Beijing has already undertaken a series of reforms in recent months, including better access for foreigners to Chinese currency markets, more frequent debt issuance and expanded yuan trading hours. The IMF expects Beijing to make more moves ‘to deepen and accelerate economic reforms and financial opening up, and contribute to promoting world economic growth, safeguarding financial stability and improving global economic governance.’