Is The Yuan Becoming A Reserve Currency? by Colin Moore, Columbia Threadneedle Investments

  • Given the importance of China in global trading, it is reasonable for the International Monetary Fund (IMF) executive board to consider the yuan for inclusion in the basket of currencies used to value Special Drawing Rights.
  • China is taking steps to improve the liquidity and transferability of its currency, but it is not clear to me that they currently meet the criteria for inclusion in the SDR basket.
  • If the Chinese government takes more substantial steps toward making the yuan fully exchangeable, allows interest rates to be set by the market, and allows free movement of capital, then their currency may evolve toward full reserve status over the medium to long term.

There has been much discussion and speculation about whether the International Monetary Fund (IMF) should include the yuan (or renminbi) in the basket of currencies constituting Special Drawing Rights (SDRs). SDRs were created by the IMF in 1969 to support the Bretton Woods system of fixed exchange rates. SDRs were initially worth 0.888671 grams of gold, which was also equivalent to one U.S. dollar. According to the IMF’s factsheet, a country participating in this system needed official reserves of gold and widely accepted foreign currencies to maintain its exchange rate. The international supply of two key reserve assets — gold and the U.S. dollar — proved inadequate to support the expansion of world trade. Consequently, the international community created a new reserve asset known as Special Drawing Rights. The SDR is not a currency; it is a claim on the freely usable currencies of IMF members. Holders of SDRs can obtain these currencies by voluntary exchanges between members or by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions.

However, Bretton Woods was disbanded in 1973 and the major currencies shifted to a floating exchange rate. The need for SDRs waned. Since then, the primary role of SDRs has been as a unit of account for the IMF, i.e., to value their own balance sheet and measure global trade, etc. Using a basket of currencies to value assets or trade flows helps reduce the volatility of valuation inherent to a single currency. The current basket includes the U.S. dollar, the British pound, the Japanese yen and the euro. The basket composition is reviewed by the IMF at least every five years “to ensure the relative importance of currencies in the world’s trading and financial systems.” The next review will occur by the end of 2015. Given the importance of China in global trading, it is reasonable for the IMF executive board to consider the currency for inclusion in the basket of currencies used to value SDRs. Today, even after an extraordinary issuance in 2009 following the global financial crisis, there are only about $320 billion of SDRs in existence. This may seem a lot, but it is tiny against the scale of global currency markets.

The use of the word “reserve” here is confusing. The SDR’s are supplementary foreign exchange reserves, but must not be confused with the common use of “reserve currency.” Reserve currencies are held in significant quantities by central banks and the private sector institutions as their primary reserve and method of purchase. A true reserve currency, such as the U.S dollar or the euro, is freely exchangeable and can be used in multiple transactions. SDRs can only be held by central banks, not private corporations or individuals, and can only be exchanged via the IMF’s SDR Department or on a voluntary basis with IMF member countries. New issuance requires an 85% majority, and voting is based on member country’s IMF quota rather than one country one vote. Therefore, the U.S. and Europe have significant voting rights. China is taking steps to improve the liquidity and transferability of its currency, but it is not clear to me that they currently meet the criteria for inclusion in the SDR. Even if China is meeting the criteria, the IMF’s own report states:

“In order to make a difference in any of these areas, the role played by the SDR would need to be enhanced considerably from its current insignificant level. Very significant practical, political, and legal hurdles would need to be overcome in the process.

“Expanding the volume of official SDRs is a prerequisite for them to play a more meaningful role as a substitute reserve asset… Even after the extraordinary allocation approved in 2009, total outstanding SDRs (204 billion) represent less than 4 percent of global reserves — well under the peak of 8.4 percent reached in the early 1970s. In part reflecting this small share, they are not actively traded.

The IMF is looking at ways to increase the use of SDRs, but there has been very little progress. However, they are keen to include emerging market currencies in the basket. In isolation, a decision to include China in the SDR basket poses minimal threat to the status of the dollar as the world’s dominant fully exchangeable reserve currency. However, if the Chinese government takes more substantial steps toward making the yuan fully exchangeable rather than just widening the permitted exchange rate bands, allows interest rates to be set by the market, and allows free movement of capital, then we should assume the currency may evolve toward full reserve status over the medium to long term. I would welcome rather than fear those reforms, but we appear to be a long way from there.

China yuan