GS-3, Indian Economy, Uncategorized

China’s inclusion in IMF currency basket

What is a Special Drawing Right?

The fund created the SDR in 1969 to boost global liquidity as the Bretton Woods system of fixed exchange rates unraveled. While the SDR is not technically a currency, it gives IMF member countries who hold it the right to obtain any of the currencies in the basket — currently the dollar, euro, yen and pound — to meet balance-of-payments needs. So the ability to convert SDRs into yuan on demand is crucial. Its value is currently based on weighted rates for the four currencies. The SDR weightings are set every day by the IMF.

The criteria as determined by the IMF for SDR basket composition are:
1) the size of country’s exports of goods and services during the five-year period ending 12 months before the revision date:
2) the currency must be ‘ freely usable’. According to the IMF’s Articles of Agreement, a freely usable currency is a member’s currency that the Fund determines a) is widely used to make payments for international transactions and b) is widely traded in the principal exchange markets.

Will the yuan dethrone ‘king dollar’?

The yuan’s inclusion in the SDR basket will bolster its reputation as a global reserve currency. But it’s far from challenging the dollar’s roll as the world’s premier reserve currency. The yuan is only the fifth most-used currency for settling international payments. Only a fraction of global central-bank reserves are denominated in yuan. This will not have much impact on short-term demand for the yuan, given the SDR’s minor share of global reserves currently been assigned to it (about 10%).

Being a reserve currency means that it should be freely usable in the international market, that would require China to open up it’s capital market also which is currently closed to more extent. Most of the foreign transaction which takes place in China goes via route of Hongkong market.
Directly opening the market to foreign world mean losing the control of the state over the domestic asset and leave it’s value to be decided by global whims.

Getting included in the basket of IMF reserve currency means that the economy of that country is quite stable which motivates foreign institutional investors to invest in the economy. Such move will also help foreign companies to issue yuan denominated bonds (Panda Bonds) which will also help Chinese bond issuers to hedge against inflation. when a bond can be issued in country’s own currency denomination, it frees the issuers against the risks posed by inflation than when they are denominated in any other reserve currency because then the value of bond depends upon the exchange rate of the two currencies at the time of redemption.

 

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