It is understandably rare that the International Monetary Fund's quinquennial review of its Special Drawing Right valuation draws much fanfare. SDR's, the IMF's standardized reserve asset that it issues to member countries, are valued based on the underlying market prices of a basket of the world's most influential currencies. During most of these review periods, the most momentous topics discussed are often meticulous adjustments to the valuation model to respond to changes in input data. However, by the end of its 2015 review, the IMF's Executive board must make a decision that will shape the future face of the international economic system.
At the moment, the SDR basket only includes the dollar, euro, pound, and yen. The currency of China, most commonly referred to as the Yuan, now has a shot at being included in the basket. This would represent a major step for the Yuan in achieving recognition as an internationally influential currency. By the majority of the IMF's evaluation metrics, and by simple observation of China's major role in the world economy, it is clear to see that now is the time for the Yuan to be included in the SDR currency basket.
To break into this elite group of currencies, IMF policy is that a currency must meet two benchmarks. First, it must be issued by one of the world's top exporters. In the case of the Yuan, there's really no argument that China is, and will continue to be, one of the world's top export powerhouses. Second, however, a currency must be deemed "freely useable". The Chinese government's maintenance of capital controls, and its continued willingness to devalue its currency calls the Yuan's fulfillment of the second requirement into question. It was for this reason that the Yuan did not pass muster during the last review in 2010.
However, the Chinese government has recognized its currency's shortcomings, and there are several policy changes coming that will seek to address the IMF's concerns. First, Yuan interest rates, which were also criticized for not being market-driven, will soon also receive a significant policy overhaul. For the first time, the PBOC will soon begin issuing short-term debt instruments. This new market will quickly establish a market-driven basis for short-term interest rates and will provide a critical metric for the determination of Yuan exchange rates.
Additionally, the Yuan's exchange rates, which previously were controlled exclusively by the People's Bank of China (PBOC), will soon instead be set by a group of both Chinese and international banks. These policy transitions, which will allow the currency's exchange rates and interest rate to be more market-driven, represents a clear commitment by the Chinese government to meeting the IMF's requirements.
Even before these policy changes, an IMF staff report assembled this summer found clear evidence that the Yuan has approached the level of use and trade of the Yen, the lowest-weighted of the current SDR basket currencies.
From 2013 to 2014, the use of the Yuan in official foreign currency assets increased by over 75% from $29 Billion to $51 Billion. While this percentage increase was, admittedly, from a comparatively small base, continued growth at just a fraction of this rate would bring the Yuan to the Yen's level of usage within the next two years. By the end of Q1 2015, 0.6% of the world's international debt securities were denominated in the Yuan, compared to 2.0% in Yen. Perhaps a more telling measure of the Yuan's use in debt markets is that 1.4% of new debt issuances were denominated in the currency. This suggests that the Yuan's share in this market will likely grow in the near future.
The IMF's report also found that the international Yuan currency market would be sufficiently deep to absorb with minimum price impact the effects of large currency purchases that might result from being included in the SDR basket. The Yuan currency exchange in Hong Kong has become one of Asia's largest foreign exchange centers, and could potentially become the world's premier supplier of Yuan. The report stated that, "even a very large Fund-related transaction would still represent less than 10 percent of a day's worth of RMB turnover". This is critical, as it is important for SDR basket currencies to be able to be quickly available to IMF member countries with minimal impact to international currency markets.
Due to the clear data indicating that the growing international use of the Yuan is a durable trend, the question of its inclusion in the SDR currency basket is really more of a question of "when" rather than "if". While the IMF Executive board has the option to delay a decision until next year, it would be a prudent symbol of foresight for the IMF to act now. Recognizing the Yuan's importance would greatly increase the IMF's legitimacy as a body truly representative of the whole international economy rather than the interests of just the U.S. and its closest political and economic allies.
**Dr. Fariborz Ghadar is founding director of The Center for Global Business Studies at Penn State's Smeal College of Business and a senior adviser at the Center for Strategic and International Studies. Cameron Stevens is Research Assistant at the Center for Global Business Studies at Smeal College of Business.