Adding the Yuan as an IMF reserve currency

Chinese stocks have been on a tear this year. Government initiatives in the banking and currency sector indicate a strident ambition to create a healthy and sustainable economy. The domestic Chinese stock market is still the best performing in the world, even with its recent correction. Its rapid rise since last winter and the 40% premium for stocks on the mainland has many bubble-watchers hoisting the warning flags. Still, market liberalization is not an overnight process. Benefits will take years to fully realize.

Nine cows, one hair

Nine Cows, One Hair

One effort that deserves particular attention is the Chinese government’s push to include the Renminbi, or yuan, as an International Monetary Fund (IMF) reserve currency. In central banks around the world, the yuan is about 0.90% of currency reserves- a drop in the bucket.

The IMF conducts most of its business in Special Drawing Rights (SDR). This is an international reserve asset designed to supplement its member countries currency reserves. The SDR is a potential claim on the “freely usable” currencies of IMF members. Every five years, the basket of currencies available is re-evaluated. The current basket includes the US Dollar, Euro, Pound Sterling and Japanese Yen (see chart 2).

The four current currencies in the SDR

The four current currencies in the SDR

The main criteria for inclusion in the SDR is that the currency be “freely usable” and the country be a large exporter. China is unquestionably a large exporter but the yuan is not yet freely usable. Inclusion in the SDR as a reserve currency is a way for the Chinese government to prove its commitment to structural market reforms. It is also a way for the rest of the world to acknowledge the major role that China already plays in the global economy. Because the SDR basket is reviewed internally by the IMF there is a better chance for inclusion in the SDR than for the majority shareholders of the IMF (US, Germany, UK, France) to reorganize the shareholder structure to recognize the growing weight of emerging market countries.

The announcement on May 26 by the IMF that the yuan was no longer undervalued was another positive sign and indeed China has taken big strides towards relaxing capital controls (chart 2). From the early 90s until late 2004, the yuan was held at a strict level against the dollar: 8 Yuan for every 1 US Dollar. The artificially maintained exchange rate kept Chinese exports cheaper and justified frustration for the remaining American manufacturers. Since 2004, however, we have seen a gradual loosening of the exchange rate, bringing the yuan to a more market defined level, closer to the dollar.

The USDCNY exchange rate from 2004.

The USDCNY exchange rate from 2000

In the push for inclusion in the SDR, the Chinese government has begun reforms to make the yuan “freely usable”:

  • A deposit insurance system began in May
  • Restrictions on Chinese buying foreign assets (stocks, bonds & real estate) have eased
  • Foreign entities are now allowed to sell yuan-denominated debt in China
  • Chinese are now allowed to issue yuan-denominated debt overseas.
  • The number of foreign investors allowed in to the interbank bond market has already exceeded the total amount approved in 2014.

Still, there are ways to go for a healthy, sustainable economy:

  • Foreign investors should be able to invest in the interbank bond market without going for government approval each time.
  • The stock exchanges cap how high and low a company can trade in one session. Trading is easily halted when things go wrong.
  • Ultimately, the yuan should become freely convertible (although not necessary for inclusion in the SDR- both the Japanese Yen and Franc were not freely traded when first added).

These efforts at changing the financial structure bode well for China’s transition from a super-growth economy. The reforms will take time to fully realize. Meanwhile, the seas will continue to be choppy.