UPDATE 3-IMF gives China’s currency prized reserve asset status

1 Dec 2015 | Author: | No comments yet »

China joins IMF currency basket: Why it matters.

IMF Managing Director Christine Lagarde said the inclusion was “clearly an important milestone in a journey that had begun months, if not years ago” to a “market-driven” economy in China.Monday afternoon, the International Monetary Fund’s (IMF) Executive Board voted in favor of allowing China’s currency — the yuan (or renminbi) — to join the ranks of the world’s most elite monies.

On Oct. 1, 2016, the yuan will officially be added to the IMF’s Special Drawing Rights (SDR) basket of currencies, which previously included only the dollar, euro, yen, and pound sterling. The decision to include the yuan in the basket indicates the board felt the yuan meets the required “freely useable” standard, meaning it is widely used to settle international transactions and widely traded in foreign exchange markets. To meet the IMF’s criteria, Beijing has undertaken a flurry of reforms in recent months, including better access for foreigners to Chinese currency markets, more frequent debt issuance and expanded yuan trading hours. “The renminbi’s inclusion in the SDR is a clear indication of the reforms that have been implemented and will continue to be implemented,” she told reporters. Currency traders and economists see the change as encouragement to Beijing to make faster progress on promises to make the yuan “freely tradable” and open its financial system. The yuan CNH= CNY= will have a 10.92 percent share, in line with expectations, after a review of the weightings formula for the SDR which also cut the euro’s share by more than 6 percentage points.

Just like individuals, governments maintain their own investment portfolios that function as a sort-of “rainy day fund.” Typically, central banks operate as their country’s investment managers, regularly making decisions about how best to allocate the government’s financial assets. But China is still criticized, particularly by the US, for manipulating its currency, typically by devaluing the yuan to bolster its exports and for some lingering constraints on capital flows. Following the global financial crisis, Beijing called in March 2009 for creation of a new currency, possibly based on the SDR, to reduce reliance on dollars but failed to attract support. These assets are appropriately referred to as “foreign exchange reserves.” Central banks typically hold a blend of currencies in their foreign exchange reserves.

The yuan is the No. 4 currency for global trade, accounting for about 2.5 percent of the total, according to SWIFT, the organization for interbank financial transfers. The addition is likely to fuel demand for China’s currency and for renminbi-denominated assets as central banks and foreign fund managers adjust their portfolios to reflect the yuan’s new status. Beijing controls the flow of money into and out of its economy but has encouraged the use of the yuan abroad, especially for trade, which helps Chinese exporters by eliminating the cost and risk of volatile exchange rates.

But analysts said investors would likely remain cautious as long as China did not fully liberalize capital controls or allow the currency to float freely. “‘Freely usable’ meant freely usable to reserve managers and available to official institutions,” said Steven Englander, head of G10 foreign exchange strategy at Citi in New York. The IMF said China’s comparatively higher interest rates would likely increase the SDR interest rate – potentially pushing up the cost of IMF loans for some borrowers. Branches of Chinese state-owned banks in Britain, Australia, Germany, Switzerland, Russia, France and Singapore have received authorization to take deposits or settle trade-related transactions in yuan.

The IMF will consider the impact of the change on its finances in April. (Reporting by Krista Hughes; Additional reporting by Jason Lange and Howard Schneider in Washington and Dion Rabouin, Daniel Bases and Sam Forgione in New York; Editing by Meredith Mazzilli and Alan Crosby) In practical terms, the SDR’s primary function is as a unit of account for the IMF, with official IMF documents reporting the institution’s own assets and liabilities in SDR terms. That might encourage more use of yuan for trade and investment. “Longer term, this is a huge step,” said Stephen Innes, chief trader for the currency firm OANDA in Singapore. “Once investors become more comfortable with Chinese markets, especially if they continue to progress with opening policies and make the same strides they did over the past year, international markets will really embrace Chinese capital markets.” Economists say the IMF decision could encourage Chinese leaders to further relax controls on the yuan. For example, the dollar’s role as a top reserve currency is one of the reasons the U.S. government is able to borrow from foreign creditors so cheaply. Governments that issue top reserve currencies need to provide large and open financial markets where foreign investors — including central banks — can buy and sell assets in the currency freely and quickly.

Governments also select their reserve currencies in part as votes about which global political order they prefer, as Steven Liao and I argue in a forthcoming article at International Studies Quarterly. Increasingly, scholars and observers are arguing that the ideas and principles that underlie the existing, U.S.-led liberal order are being contested.

Consequently, national decisions to invest in yuan may be symbolic repudiations of American dominance, and endorsements of an alternative world order with Chinese characteristics. Using a new measure of satisfaction with the U.S. order by Michael Bailey, Anton Strezhnev and Erik Voeten, we find that the single best predictor of an official investment in yuan is a country’s (dis)satisfaction with the U.S.-led order. China must also further open its domestic financial markets to foreigners and remove its grip on the yuan’s exchange rate if it is to truly challenge the dollar. Thus what may emerge over time is an increasingly politicized global reserve currency system where geopolitical preferences influence the “blend” of currencies central banks hold in their coffers.

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