For the first time in 15 years, the International Monetary Fund (IMF) has changed the structure of the special drawing rights (SDR) basket and has announced the Chinese yuan to be a new official foreign reserve asset. This change not only acknowledges China's monetary reforms, but also accelerates the yuan’s internationalization. This blog will explain the challenges and benefits that China is facing with respect to the inclusion of its currency in the SDR basket.
The official inclusion of the yuan in the SDR basket will not happen until October 2016. This means that China is under pressure to free up its currency market and open up its capital accounts. For a long time, the Chinese government tended to intervene in the currency market. For example, there are controls on how much money Chinese investors can send out of the country and how many domestic assets overseas investors can buy. In order to maintain the reserve status, the yuan has to be “freely usable”, and therefore economists expect Chinese authorities to take steps in the coming years to address the current currency trading limitation. Moreover, with less governmental intervention in the currency market, the yuan is expected to decrease in value, given China’s recently slowing economy and the strong U.S. dollar. As China is shifting quickly from an industrial economy to a retail economy, the yuan’s devaluation will slow down the process to some extent as Chinese industrial products become cheaper.
However, as China allows markets to be more open and accessible to foreign investors, it gives investors opportunities to invest in Chinese companies that are not listed on the Hong Kong and New York exchanges. As research has shown, foreign investments improve productivity for the host country. China is no exception, as it adopts more advanced foreign technologies and creates closer linkages between foreign and domestic firms. Furthermore, as BRIC countries are shifting to the use of local currencies in mutual trade and investment and the majority of the exchanges involve China, the yuan’s reserve status will make it more stable and hence reduce the exchange rate risk. This will help boost China’s exports and the growth of the trade with foreign countries.
Analysts indicate that the inclusion of the Chinese yuan will not have immediate impacts on the currency market, but in the long run, demand for the yuan is expected to rise as China gradually loosens its trading restrictions. Challenges and opportunities exist side by side with respect to the yuan’s inclusion in the SDR basket. The major step that Chinese authorities need to take in response to this change is to free up the markets and allow the yuan to be more “freely usable”.