The Chinese yuan is becoming a central currency: 6 things you need to know

The Chinese yuan is becoming a central currency: 6 things you need to know

December 1, 2015 Good Reads 0 Comments

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Shareholders in the International Monetary Fund voted on Monday to let the Chinese yuan (CNY) into the fund’s basket of reserve currencies. It will now be a member in the IMF’s elite club called the Special Drawing Rights (SDR). But what exactly does this mean? Here are six things to know about the decision.

The SDR itself is not a currency

The IMF created the SDR in 1969 as a supplement to foreign exchange reserve assets like gold and the U.S. dollar. In order to participate in the Bretton Woods system — the first attempt at institutionalizing monetary relations among independent nations — countries needed government holdings of gold and widely accepted foreign currencies. However, there was limited international supply of both gold and the U.S. dollar and therefore the IMF decided to create the SDR. The IMF actually allocates SDRs to its 188 member countries in proportion to their share of the global economy. (A reserve currency is a foreign currency held by central banks in significant quantities that is used in international transactions and is typically considered a “safe haven” currency.)

The basket originally had 16 currencies

The yuan is the fifth currency to comprise the SDR basket along with the U.S. dollar, the euro, the Japanese yen and the British pound. But the basket originally began with 16 currencies. It was then reduced to five in 1981, and to four in 1999 when the euro replaced the German mark and the French franc.

The yuan was up for review in 2010

The IMF conducts a review of the SDR currencies every five years. During its last look in 2010, the executive board (24 directors) concluded that the existing four currencies would continue to comprise the SDR basket. China had met the gateway criterion but ultimately, the yuan — also called the renminbi — wasn’t included because it was not judged to be “freely usable,” which means a currency that’s widely used to make payments for international transactions and widely traded in exchange markets. Since then, Chinese President Xi Jinping has prioritized serious reforms, including longer trading hours for the currency and more frequent debt issuance.

Not all currencies are weighed equally

With the yuan joining the club, the IMF had to develop a new weighting formula, which is based on factors like the value of the issuers’ exports and foreign exchange turnover. The yuan will officially become a member of the basket as of Oct. 1, 2016, and the currencies will be weighted as follows: U.S. dollar — 41.73%; euro — 30.93%; yuan — 10.92%; yen — 8.33%; pound — 8.09%.

SDRs can be traded among IMF members

Because SDRs are not a currency, they can’t be used to purchase goods or services directly. However, countries can exchange them with one another, but they must first be converted into currency before use. Once the SDRs have been added to a country’s official reserves, a country can exchange its SDRs for hard currencies through individual trading agreements. Also, a country’s financial aid payments are denominated in SDRs rather than a single currency. For example, Greece made IMF payments in SDRs, not euros.

It’s mostly a symbolic move

IMF Managing Director Christine Lagarde said on Monday that the inclusion of the yuan into the SDR basket “will bring about a more robust international monetary and financial system, which in turn will support the growth and stability of China and the global economy.” Essentially a vote of confidence from the IMF, the inclusion might be an opportunity for China to use the move to continue its efforts on transparency and reform. And more tangibly,currency analysts say this move could fuel global demand for the yuan worth $500 billion over the next few years. How fitting for a currency which literally translates to the “people’s currency” in Mandarin.

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