Yuan Set To Hit The Big Leagues

November 16th, 2015 by

yuanThe big news in currency markets this morning is the recommendation by a policy committee of the IMF that China’s currency, the yuan, be included in the Special Drawing Rights basket of currencies. Forex traders put the odds of the yuan’s inclusion in the SDR at the IMF’s November 30 meeting at around 80%. This is a status that the Chinese government has chased for decades, considering it acknowledgement that China has become a major player on the world economic stage.

What Is The SDR?

IMFWhile defined as a reserve currency, the SDR is actually a financial instrument for central banks invented by the IMF. It’s a weighted basket of the most important world currencies. The current weighting is: The US dollar (41.9%,) the EU euro (37.4%,) the United Kingdom’s pound (11.3%,) and the Japanese yen (9.4%.) The SDR, which counts as part of a central bank’s reserves, can be converted on demand to any of the “freely usable” currencies.

The inclusion of the Chinese yuan (official name: renminbi) will force a rebalancing of the weight each currency carries in the SDR basket. At this point, it is unknown who the biggest losers in this reshuffling will be.

Long March To Reserve Status

Yuan Mao shown on a Chinese currency note.

Mao shown on a Chinese currency note.

SDR inclusion will mark a huge milestone in the Chinese government’s efforts to promote the yuan to reserve currency status. While Beijing has inked several bilateral currency agreements (mostly with the nations that supply China’s raw materials) the renminbi has, until now, not met the criteria for SDR inclusion. Reforms of the financial system pushed through by Chinese president Xi Jinping and the reformist wing of the Chinese Communist Party have met most of the IMF’s criteria for SDR inclusion, at least on paper.

Another hurdle is reconciling the yuan (CNY) with the “offshore” yuan (CNH) used in international transactions. The CNH is allowed to trade freely, but is not allowed in transactions in mainland China. This has allowed Beijing to insulate its domestic economy from currency fluctuations. Recent reforms to expand the daily band the CNY is allowed to trade is the most visible step towards eventually uniting the two currencies.

Can Beijing Leave The Yuan Alone?

yuan-vs-dollarOne of the most important criteria of a reserve currency is that its value is allowed to float freely on the global forex market. This may be the hardest part for the Communist government to meet. Although Beijing shocked the world in August with a surprise devaluation of the yuan, it still sets an “allowable” daily trading band. It has also brazenly intervened in the currency markets by buying up yuan (usually by selling dollars) to prevent it from falling too far in one day.

As the day gets closer when the distinction between onshore and offshore yuan disappears, the Chinese central bank has also started manipulating offshore yuan to reduce the spread in value between the two.

Could Market Reforms Be Reversed?

china-flag-shanghaiLetting the yuan freely move in global currency markets goes against everything the “Old Guard” in the Chinese Communist Party has believed since their rise to power in 1949. As the Chinese economy continues to weaken, the population will look to Beijing to “make things right,” as they always have. This will weaken the resolve of the reformers, and increase pressure to revert to a centrally-controlled economy. Economic conditions have already pushed back the timetable on planned financial reforms, and critics say they may be scrapped altogether after the IMF approves the yuan’s inclusion in the SDR basket.

It’s All About Respect

Chinese president Xi Jinping

Chinese president Xi Jinping

According to international clearing house SWIFT, the yuan makes up less than 3% of international forex settlements. However, inclusion in the SDR will give the reformers in China more power, as backsliding afterwards would cause a loss of face in the eyes of the world.

China will be the first emerging market to gain the recognition of being a global reserve currency. This is a huge deal in China, where people believe the nation has not received the respect it is due, being the world’s second-largest economy.

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.