Dragon enters SDR league; poses challenge to dollar-dominant trade

How the Chinese Central Bank manages with market forces in allowing them to determine currency valuation remains a real challenge

By Sai Nikesh D

Reflecting the relative importance of Chinese currency in the global trading and financial systems, the International Monetary Fund (IMF) on November 30 announced inclusion of the Chinese Renminbi (RMB) into the global reserve currency basket.

In a landmark decision, IMF Executive Board decided that, effective October 1, 2016, RMB is determined to be freely usable and be included as a fifth currency in the Special Drawing Rights (SDR) basket, along with USD, Euro, Japanese Yen and British Pound.

Yuan now is an asset that can be exchanged for other currencies and is used by SDR fund to provide liquidity or emergency lending to troubled nations.

In view of the fact that SDR gives IMF member countries the right to obtain any of the currencies in the reserve to meet balance-of-payments needs, the ability to convert SDRs into Yuan on demand turns crucial, which is probably a curtain-raiser for China’s long-standing wish.

Long-standing wish!

China had, in many occasions, pitched for entry of its currency into the international reserve currency basket.

Sounding of the wish echoed in the People’s Bank of China (PBoC) Governor Zhou Xiaochuan’s statement in 2009, where he said, “The global financial crisis underscored the risks of a global monetary system that relies on national reserve currencies and there is a need for SDR to take on the role of a ‘super-sovereign reserve currency,’ with its basket expanded to include currencies of all major economies.”

What for China and the world?

With its already-existing status as one of the most-preferred trading partner, supplemented by IMF’s recognition as the ‘freely usable’ currency, China once again proved its presence as a key global player.

Inclusion of RMB into SDR may give a boost to global firms to up investments in Yuan-denominated assets. However, there also exists other side of the coin which points to ‘Yuan depreciation’.

In fact, IMF’s ‘freely usable’ tag may place pressure on PBoC, where exists a real challenge on ‘how the PBOC would manage market forces like the way the developed economies usually does by allowing market forces to determine their prices’.

It has also to be understood that the IMF will continue to push China for Yuan capital market mature with more diversified transactions both on and off shore.

More accessibility of Yuan to the world markets is also expected to bring in more FDI into China, alongside boosting capital outflows from the country.

This also signals that PBOC, from here on, will need to be more careful in deciding the rates, unlike the way it usually deals with its trading partners at the start of a trading day.

Even though there might be a low pace in immediate term due to existing slowdown of Chinese economy, an increased Yuan purchasing is being expected by the industry in the long-term.

Besides all these points, the time seems to have arrived to wait and see how China will play its role in fulfilling its long-awaited wish to implement financial reforms it needs to support long-term economic growth and continue its pace as the leading nation in the global trade.

It’s high time for competition!

Industry and market research analysts feel that the Chinese currency, by being widely-used and widely-traded, meets major criteria to be part of the SDR basket.

The IMF’s move is anticipated to lead the global financial system towards a paradigm shift from the dollar-dominated trade, supplemented by the fact that the majority of the countries including the US stand in trade deficit with China.

Here, it is noteworthy to mention about China’s dependence on energy and oil imports, which mostly happens in dollar terms, is also a key point where China may have to face dollar confrontation.

Through this move, China becomes the first developing country to join the IMF’s international currency basket.

Background:

In its concluding discussion on the annual review of Chinese economy on August 14, 2015, IMF urged China to achieve an effectively floating exchange rate system in the coming two to three years period, as it becomes more nearer to global financial markets.

Nevertheless, a more market-determined exchange rate would facilitate SDR operations in case the Renminbi were included in the currency basket going forward, the IMF said.

This clearly means that Chinese currency will be under a continuous IMF watch over its moves towards its trading partners and SDR member countries.

How important is SDR for global economy?

SDR played a key role in bringing out its member countries’ at times of crisis.

The SDR allocations in 2009 totalling SDR 182.6 billion played a key role in providing liquidity to global economic system and supplementing member countries’ official reserves amid the global financial crisis.

As of November 30, 2015, $285 billion SDRs had been created and allocated to members.

More currencies into SDR!!

The IMF revises its SDR list after every five years and is most likely to add additional currencies to the list.

Based on export rankings, South Korea is likely to be the next currency to join SDR basket, followed by Singapore and Canadian dollars. However, none of them were found among top six among the main financial indicators weighed by the fund.

One will have to wait till the next review which has been scheduled to take place by September 30, 2021, to see which all currencies will get an entry pass to SDR basket

                                                                                                                              Posted on December 10, 2015. IST

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