The International Monetary Fund’s (IMF) executive board, which represents the fund’s 188 member nations recently included China’s Yuan into its Elite Reserve Currency basket. Yuan’s entry into the basket takes effect from 1st October 2016. Yuan, also known as Chinese Renminbi (RMB) was included in the basket after it met the existing criteria for its inclusion. The action was taken after the executive board at IMF completed the regular five-yearly review of the basket of currencies that make up the Special Drawing Right (SDR). – This was the highlight. Now let’s first look at the terminology to understand the impact of inclusion of Yuan in the Elite Reserve Currency.
What does Inclusion mean?
Yuan will be a freely usable currency and will be included in the SDR basket as the fifth currency, along with the US Dollar, Euro, Japanese Yuan and British Pound. Launching date of new SDR basket on 1st October 2016 was decided in order to provide sufficient lead time for IMF, its members and other SDA users to adjust to these changes. Weightings will be 41.73 percent for the dollar, 30.93 percent for the euro, 8.33 percent for the yen and 8.09 percent for the British pound. The dollar currently accounts for 41.9 percent of the basket, while the euro accounts for 37.4 percent, the pound 11.3 percent and the yen 9.4 percent. After inclusion, China’s currency will have 10.92% weighting, topping yen and pound. The inclusion of the Yuan will enhance the attractiveness of the SDR by diversifying the basket and making it more representative of the world’s major currencies. Inclusion of Yuan in the SDR is considered as a big political victory for China as Yuan’s desirability as a reserve currency for investors will increase and undermine the hegemony of the dollar as a global reserve currency. It also recognises the progress that the Chinese authorities have made in the past years in reforming China’s monetary and financial systems.
What is SDR?
The special Drawing Rights (SDR) system was created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system. SDR is an international reserve asset which the IMF uses to supplement the member countries’ reserves. The SDR value is based on the basket of the four international currencies and SDRs can be exchanged for “freely usable” currencies. SDRs are allocated to IMF members from time to time. From October 2016, once the Yuan is added, the basket will have five currencies.
What are the Criteria to get added to SDR?
- The SDR basket, upon which the SDR’s value is based, is typically reviewed every five years by the IMF’s executive board. It is reviewed to ensure that it reflects the relative importance of currencies in the global trading and financial systems.
- The last time that happened was in 1999 when the newly created Euro single currency was added, although technically it replaced the outgoing German deutschmark and French franc.
The main criterions to become eligible to be included in SDR are as follows:
- Export Criterion: To become a part of the basket, exports of a particular country shall have the largest value over a five-year period. In other words, the concerned currency that is to be included in the basket are those issued by the IMF members or currency unions that plays a central role in the global economy.
- Freely Usable Criterion: To join the basket, a currency must also be judged by the IMF’s executive board to be “a freely usable currency”. In other words, it must be a currency that is widely used to make payments for international transactions and widely traded in the main exchange markets.
Impact of this move
The Yuan will become one of the currencies used in the disbursement and repayment of international bailouts denominated in the fund’s accounting unit, like Greece’s debt deal. One of the major impacts would be on the western countries. As the Yuan becomes more deeply woven into the global economy, it will undermine the ability of the West to impose financial sanctions on countries accused of human rights abuses and other violations, like Sudan and North Korea.
In order to match to the requirements of IMF, China changed its way it sets the value of Yuan each morning, allowing market forces to play a bigger role. Inclusion in the SDR will only deepen the expectations that China will let market forces decide the yuan’s exchange rate. The point of the SDR is to weave disparate currencies together into a single, diversified unit. In that transition, China may well come to regret winning this honour, as the Yuan will lose value, possibly a lot of value. A weaker Yuan will not be entirely bad. It will make China’s exports somewhat more affordable for the rest of us and may help some Chinese manufacturers stay afloat. At the same time, China will pay more for what it imports from other countries. Beijing is trying to build internal supply and demand, but it isn’t clear how ready they are for a floating currency. It is currently applicable for China that “Making it more market-based makes it more difficult to manage, but making it more market-based also makes it more efficient.
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