3 December 2015

IMF Admits Yuan to SDR Currency Basket

Regular readers know that we have written a lot about the currency markets and some of the major changes that will take place in the coming years. This week on Monday China’s currency, the Yuan was admitted into the IMF’s Special Drawing Rights (SDR) currency basket.

Currently the SDR is made up of the Euro, Japanese Yen, British Pound and the US Dollar. Earlier this month the head of the International Monetary Fund (IMF) Christine Lagarde tipped her hand that the Yuan would be included in the SDR currency basket.

According to a Bloomberg article, in a Nov. 13 statement, Lagarde said staff determined the Yuan is “freely usable,” which is the test for inclusion. (Source: Bloomberg: 2015 November 29th)

The Yuan will be the Fifth Currency in the SDR Basket

While the IMF announced on November 30th that the Yuan will be the fifth currency in the SDR basket, China will not officially join the SDR until October of 2016. Another noteworthy point is that according to a Reuters story, a person familiar with the IMF deliberations said that the decision to include the Yuan was unanimous. 

In the same Reuters article, after the announcement, Malcolm Polley, chief investment officer at Stewart Capital Advisors said: 

"Ultimately China would like to see, as a number of countries would, the dollar end its reign as the global reserve currency”. (Source: Reuters 2015 December 1)

So while it will take time for the Chinese currency to gain traction on the world stage, the move by the IMF represents a big shift the future direction of the currency markets. 

While the Dollar will still be the go to reserve currency for the foreseeable future, the internationalization of the Yuan will mean more countries and investors will eventually turn to the Yuan and away for the Dollar.

What is the Purpose of SDR’s

The Special rights system was created in 1969 by the IMF to support the Bretton Woods fixed exchange rate currency system. However, back then Gold and the US Dollar were the only reserve assets and not adequate to support the expansion of global trade. As a result, the SDR basket provided more global liquidity. 

The Bretton Woods system fixed other currencies to the US Dollar and the Dollar was pegged to Gold. But when the Bretton Woods system collapsed in 1971 the Dollars peg to Gold was abandoned. This is when world currencies shifted to a floating exchange rate system and the SDRs were viewed as a more important reserve asset. So SDR’s can be exchanged for other international currencies. But only the so called “elite currencies” can be included in the SDR.

There is also another reason why the SDR is a reserve asset in the global economy. Part of the role of the IMF is to issue loans to troubled economies like Greece. When it does so it sometimes issues these loans in SDR’s.

Allocation of Currencies in SDR Basket

It is also a big deal for the IMF to adjust the SDR basket. The last time this happened was in the year 2000 when the Euro replaced the the German Deutschemark and the French Franc.

Prior to the addition of the Yuan, the weighting of the currencies in the SDR basket consisted of 41.9% for the Dollar, 37.4% for the Euro, 11.3% for the Pound and 9.4% for the Yen.

According to an article in Reuters, the new weighting will now consist of 41.73 % for the US Dollar, 30.93% for the Euro, 8.09% for the Pound and 8.33% for the Yen and the Yuan will have a 10.92% share. (Source: Reuters 2015 November 30th)

What is interesting about the new formula for the SDR is that the Chinese currency has a higher percent allocation than the Pound and the Yen. 

Only a Symbolic Move?

Some financial analysts and writers argue that the entry into the SDR basket is largely just a symbolic move for China’s currency. They point out that according to Bloomberg, the outstanding value of SDRs is just over $300 billion, which is only 2.5% of global currency reserves.

However, these analysts are underestimating the strength and power a reserve currency status gives a country. This symbolic move allows China to now expand the Yuan into a truly global currency.

Also as of now, the yuan only accounts for about 2.8% of total global payments. But with China being the worlds second largest economy this percentage will grow significantly in the coming years. 

Use of the Yuan is already expanding. According to an article in Bloomberg the Yuan overtook the Yen as the fourth most used payments currency. (Source: Bloomberg 2015 October 6th) The Yuan is set to likely become the the preferred payment currency for all of Asia. And Asia is where most of the future growth lies in the global economy.

According to the article, the top three currencies with the largest share of payment volumes are the US Dollar at 45%, the Euro at 27% and the Pound at 8.5%. So clearly the Yuan has a way to go before it catches the Dollar, Euro and Pound.

However, China has now taken the important step of establishing the Yuan as a reserve currency. While the announcement by the IMF could be viewed as only symbolic over the short term, over the longer term it will be significant.

Why this is Significant

With China currently being the worlds second largest economy, entry into the SDR is a big deal. Now the Yuan will be included into the inner-circle of the worlds most prestigious currencies.

The move will also help to generate more interest from investors to gain access to investment markets in China. With the internationalization of the currency, investors will soon be able to access Chinese investment markets using the Yuan, which up until now really has been limited.

Billions of Euro’s, Dollars and Yen will move into the Yuan as it achieves reserve currency status. Over time this will enable China to play an even bigger role in trade, settlement and investment markets.

In addition, according to an article in Business Insider, last week Beijing announced that an initial group of Central Banks were allowed to enter the Chinese currency market. (Source: Business Insider 2015 November 29th)

This is another step toward making the Yuan a reserve asset used by Central Banks.

What about China’s Economic Slowdown 

Along with most countries in the world economy, China is also suffering from debt and credit problems that could turn into a major depression. China’s manufacturing activity is slowing down.

According to an article in Business Insider, China’s manufacturing activity levels now contracted for four consecutive months, the longest stretch since the global financial crisis. (Source: Business Insider 2015 November 30th)

So the news in China is not all good. However having a global currency that investors recognize as stable is a major step for China to take more a lead role in the global economy. 

Gold and the Yuan

The pundits may be right that the IMF decision will not have an immediate impact on the currency markets. However the bigger impact in the future is whether the Yuan will eventually replace the US Dollar as the world leading reserve currency, which many believe to be the case.

This may be the reason why China is continuing to acquire enormous amounts of Gold. Having a huge stockpile of Gold is going to be needed to establish confidence in the market for the Yuan to be the world reserve currency.

Author: celticgold.eu

Older Gold Demand Update Newer CelticGold Market Report December 7th 2015