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What does yuan's inclusion into SDR basket really signify?

A US $100 banknote is placed next to 100 yuan banknotes. Photo: Reuters

The addition of the Chinese yuan into the International Monetary Fund (IMF)'s Special Drawing Rights (SDR) basket has sparked heated discussions over the country's future monetary and financial reforms and the currency's internationalization.

On December 1, the Chinese yuan, also known as the renminbi, was approved by the Washington-based international organization to join the SDR basket as the fifth reserve currency, which is currently made up of the US dollar, euro, Japanese yen and pound sterling.

According to the IMF's assessment criteria, if a currency wants to be added to the SDR basket, its issuer must have been a major exporter in recent five years and the currency must be freely usable. A freely usable currency refers to a currency that is widely used for international transactions and widely traded in the principal foreign exchange markets.

The IMF conducts a review of currencies which seek an entry into the SDR basket and which have already been in the reserve currency basket every five years. In 2010, China lost its bid to enter the SDR basket due to the IMF's denial of the yuan as a freely usable currency.

Symbolic or real significance?

After the IMF's decision to add the yuan to the SDR basket, many economists and media, especially those from the West, viewed what China calls a milestone in its effort to internationalize its currency as symbolic, citing the Chinese government's still-tight control over the yuan's valuation. On the contrary, the Chinese media hyped the victory as an indication of China's growing say in the global economy.

It is an irresistible trend that the yuan is added to the SDR basket as it conforms to China's development path and meets the international call to adjust the current international economic and financial system, said China's official Xinhua News Agency, depicting the yuan's SDR basket inclusion "well-reasoned" due to the currency's important position in the international trade finance and payment.

The yuan has become the world's second-largest trade financing currency, the fourth most-used currency for global payments and ranks seventh among currencies in foreign governments' reserve assets. In the first quarter of 2015, 27 percent of China's total cross-border trade settlement was denominated in the yuan. HSBC predicted that the number will grow to 50 percent by 2020. In 2014, the yuan accounted for 1.1 percent of foreign exchange reserve assets held by foreign governments.

Shen Jianguang, managing director and chief economist at Mizuho Securities Asia, said in an article that the yuan's SDR basket inclusion will play a strategic role in bolstering foreign holders' confidence in the yuan and increasing the currency's international influence and reliability, despite the fact that the SDR, an accounting unit of the IMF, cannot be directly used for international trade payment and settlement.

Zhou Xiaochuan, governor of the People's Bank of China, the country's central bank, has pointed out that the 2008 global financial crisis reflects the inherent flaw of the US dollar-based international monetary system because the US is unable to stabilize its currency's value while providing global liquidity.

"The addition of the yuan in the SDR basket is helpful to the stabilization of the global financial market and the safety of the international reserve assets," said Shen.

However, many Chinese economists admitted that the foreign governments are not likely to drastically increase their holdings of the yuan as their major foreign exchange reserve currency in one stroke. And there are reports saying that the IMF's decision to add the yuan to the SDR basket is aimed at pressing China to further monetary and financial reforms. China has long been criticized by the US for manipulating the yuan's exchange rate.

Currency stability

The inclusion of the yuan in the SDR basket has fueled speculation that the currency will continue to depreciate on the ground that the Chinese central bank has to meet the IMF's requirement to weaken its grip on the yuan's exchange rate, a principle the IMF has long clamored for. The argument has been denied by Yi Gang, deputy governor of the People's Bank of China.

At a press conference on December 1, Yi told reporters that there is "no basis for the yuan to continue to devalue" due to China's relatively large trade surplus, continued increase in foreign direct investment and overseas direct investment, and the abundance in the foreign exchange reserves. The banker said that the Chinese government currently adopts a market-driven floating exchange rate regime with proper regulatory intervention in case of drastic fluctuations in the yuan's exchange rate. The road to the full floating of the exchange rate is a "gradual and long process", admitted Yi.

Wang Tao, chief China economist at UBS AG, predicted that the entry of the yuan into the SDR basket will not lead to drastic fluctuations in the yuan's value and large-scale capital outflows. "I believe that the yuan will not offhandedly and greatly depreciate, as the Chinese leadership hopes to promote the yuan's internationalization and values the currency's international political effect. It means that the aim of China's monetary policy is to keep the yuan basically stable. The Chinese leadership is also worried that drastic devaluation of the yuan will cause substantial capital outflows, which in turn will give rise to a further round of devaluation," said Wang.

In August, the People's Bank of China surprised the markets by allowing the yuan to devalue against the US dollar by nearly 2 percent in a monetary policy shift, which the central bank said was aimed at creating a more market-determined exchange rate mechanism. The abrupt move was described by some experts as a technical measure the Chinese government took to usher the yuan into the SRD basket.

In response to a reporter's concern over the capital outflow caused by the yuan's SDR basket inclusion, Yi said at the December 1 press conference that the reforms and SDR basket inclusion will boost two-way flows in and out of the yuan, keeping the exchange rate relatively stable.

Long road toward internationalization 

In an article, Huang Wentao, chief macroeconomic analyst at CITIC Securities, said that the yuan is far from becoming a currency that can be freely used, which is based on the fact that the yuan just accounts for a tiny part of the global foreign exchange reserve assets and that the offshore yuan market is still very small. The yuan's current share of global foreign exchange reserves is about 1 percent.

However, the yuan's SDR basket inclusion shows the IMF's recognition of the progress China has made in the monetary and financial reforms over the years. And with the IMF's endorsement of the yuan as a freely usable currency, the Chinese currency will be increasingly used in the organization's loan transactions and its status of global reserve currency will be nominally enhanced.

Huang predicted that in the long run the yuan is expected to be the fourth-largest reserve currency after the US dollar, euro and British pound, as the yuan is widely used for international payments, surpassing the Japanese yen. The analyst also said that the yuan's SDR basket inclusion will leave the Chinese government no leeway to reverse the course of its reforms in the financial system and marketization, predicting that more overseas financial institutions and enterprises will be allowed to invest in domestic financial market with the yuan's internationalization.

The People's Bank of China has hitherto made four breakthroughs in its push to open China's monetary and financial markets. Firstly, the Chinese central bank has given foreign central banks, international financial institutions and sovereign wealth funds access to the domestic interbank bond and foreign exchange markets. Secondly, the Chinese central bank established China's exchange rate formation mechanism to allow the yuan's central parity rate to better reflect the market rate. Thirdly, the Chinese central bank abandoned the ceiling limits on all deposit interest rates to make interest rate liberalization a reality. And lastly, the Chinese central bank enhanced its transparency in the foreign exchange reserve data by reporting to the IMF's Special Data Dissemination Standard (SDDS).

"The Chinese government should institutionalize the already-completed monetary and financial reforms in order to stand the test of the SDR basket inclusion criteria," said IMF deputy managing director Zhu Min, adding that the yuan's SDR basket inclusion is symbolic but substantially significant. Zhu said that the Chinese government has stepped up the pace of capital account liberalization by achieving full or partial convertibility in more than 30 out of 40 items under the IMF's classification of capital account transactions.

However, some economists warned that the Chinese government should be cautious in opening the capital account, saying that the cross-border capital flows are characterized by obvious periodicity, which will be detrimental to the stability of the domestic economy. Since the 2008 global financial crisis, international hot money has proven to have an effect on the economic operation of the emerging countries.

"Capital account opening should be a gradual process," said Zhu.

No challenge to US dollar

The IMF's decision to add the yuan to the SDR basket has created an illusion that the yuan can be used in the same way as the US dollar and can challenge the greenback's dominant position in the world.

X. Rick Niu, chief executive officer of Starr Strategic Partners LLC at Starr Companies, disagreed. He said that the yuan's SDR basket inclusion does not mean that the Chinese currency can be on par with the US dollar, which grasps 63.7 percent of the global total foreign exchange reserves, and which has gained ground since the European debt crisis.

Niu pointed out that the yuan's addition to the SDR basket is a win-win outcome for both China and the US, as the two currencies could join forces to enhance the SDR's share in the global asset allocation and the collaboration could promote the development of the new pattern of relationship between the two great powers.

In terms of the yuan's global use in shopping, travel and investment, Huo Deming, professor at the China Center for Economic Research of Peking University, said that he did not see the yuan's SDR basket inclusion benefiting ordinary Chinese people within two or three years.

The Chinese government has the right to determine to which extent the yuan can be freely used, which means that it is based on the government's policy, said Huo, adding that no international organization including the IMF can decide which currency is freely usable.

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