IMF Grants Reserve Status to the Yuan, but is it Premature?

China has taken great strides towards making their financial markets freer with the goal of gaining reserve status for the Yuan. The IMF has obliged and will include it in its SDR basket. But is the inclusion warranted, or was this a premature move by the IMF?

The IMF announced yesterday that it would include the Chinese Yuan Renminbi having met its criteria to be included in its Special Drawing Rights (SDR) basket. The SDR basket, which is currently made up of the USD, the Euro, the Pound and the Yen, is an asset the IMF created in 1969 to supplement countries reserves that were heavily reliant on Gold and the Dollar. As the world moved to a free floating system, the SDR remained an important tool for supplementing reserves, especially during the GFC, and can be exchanged for “freely usable” currencies of IMF members.

The criteria the IMF has imposed for inclusion in the SDR basket is open to interpretation. The IMF executive board reviews the SDR so it “reflects the relative importance of currencies in the global trading and financial systems”. In determining if the Yuan should be included, it must be “a freely usable currency”, which the Yuan was not up until recently. It must also “play a central role in the global economy”.

The weighting of the basket is also open to interpretation as it is determined by the “relative importance” of each currency. The IMF uses a complex method based on value of exports, the amount of reserves denominated in the respective currencies that were held by other members of the IMF, foreign exchange turnover, and international bank liabilities and international debt securities denominated in the respective currencies. When the Yuan is included on the 1st October 2016, the weights will be as follows: USD 41.73%, EUR 30.93%, CNY 10.92%, JPY 8.33% and GBP 8.09%. The Euro and pound will be the big losers when the basket is reweighted, falling from 37.4% and 11.3% respectively.

The PBOC has recently taken steps to ensure the Yuan reference rate is set relative to the previous days close. So to an extent the market decides the value, although just how the reference rate is calculated is unclear. The restricted state of capital flows from China is an obvious hindrance to a market driven currency, so the IMF is clearly using the term “freely usable” with certain amount of liberty.

The decision has been called a political one by many market observers and they have a good reason to call it that. Many believe the IMF has pushed China to open up its financial system and this move is believed to help that happen even faster. The PBOC itself has said "Going forward, China will continue to deepen and accelerate economic reforms and financial opening up, and contribute to promoting world economic growth, safeguarding financial stability and improving global economic governance”.

But there certainly are questions about whether the IMF has jumped the gun here and should wait until more transparency is evident. Growth in China is currently at 6.5% according to official figures, but that figure is heavily disputed, with market consensus closer to 3.5%. The ban on selling in the stock markets (not just short selling, any selling) is a perfect example of the government’s heavy handed approach to the financial system.

The IMF has announced it will include the Yuan in its basket of currencies, but as we can see it’s largely a political move. Until such fundamental issues can be sorted out in China’s financial system, it is a stretch to call the Yuan “freely usable”.