Yuan follows the dollar and the euro

The International monetary Fund (IMF) decided at the end of last year to include the Chinese currency yuan - also known as the renminbi - in its currency basket, called the special drawing rights (SDR).  

The SDR was introduced by the IMF as a unit of account in 1969, as an artificial currency for the world's central banks. It initially composed of five currencies: the US dollar, the Japanese yen, the British pound, the German deutschmark and the French franc.

The share of these currencies within the SDR basket reflected the size and clout of each country's economy. That meant the dollar accounted for over 40 percent of the SDR basket. While the share of the deutschmark in the basket grew over time, that of the franc and the pound declined. The Japanese yen's share, meanwhile, went through ups and downs.

After the euro's introduction 16 years ago, the mark and the franc in the SDR basket were replaced by the common European currency. Against this background, the Chinese yuan is becoming the first really new member to join the IMF's currency basket.

But there's an array of differences between the yuan and the other four currencies.

"The other four are freely floating currencies and there is no government intervention in their exchange rates," says Rolf Langhammer, former vice president of the Kiel Institute for the World Economy (IfW).

In China, on the other hand, exchange rate fluctuations are closely monitored and managed by officials. Furthermore, there are capital controls, meaning money flows into and out of the country are regulated by the government.

Despite these factors, Henning Vöpel, director of the Hamburg Institute of International Economics (HWWI), believes the IMF's decision on the yuan was justified. "The move reflects the Chinese economy's growing importance in the world. At the same time, it's also a form of encouragement for China to continue working towards transforming the yuan into a convertible currency."

A reward for reforms

China has persistently pursued the internationalization of its currency in recent years. The yuan is now the most widely used currency for payments involving Chinese trade in the Asian region. Meanwhile, the offshore markets are growing rapidly. And the yuan-denominated titles are being assigned cute names such as Dim Sum bonds or Panda bonds.

And the inclusion of the yuan in the SDR basket is regarded as a reward in some respects for the financial market reforms the Chinese government has implemented in recent years. After it became a trading currency and an investment currency, the yuan will now officially be a reserve currency.

The yuan's 11-percent share in the basket comes mainly at the expense of the euro, whose share declines from about 37 percent to nearly 31 percent as a result.

Langhammer believes it's a right decision. "The significance of the euro in overall international payments is in decline. Its importance in international trade is also no longer as dominant as it was before," he said.

Economist Vöpel even views the drop in the euro's share in the SDR as a positive development. "The euro, as the second most important reserve currency, is in a critical condition. The addition of the yuan therefore provides some relief to the euro."

Is the leap of faith justified?

The inclusion of the yuan in the SDR basket is likely to lead to greater demand for the Chinese currency. Central banks worldwide will give it a more prominent place among their monetary reserves, although they are under no obligation to replicate the composition of the SDR.

Langhammer, the IfW economist, says it's uncertain whether or not the yuan will be able to gain widespread trust. "Investors and businesses would like to hedge risks associated with exchange rate fluctuations. But that's not possible with a currency like the yuan, whose trade-weighted basket of currencies is dominated by the dollar."

Against this backdrop, it's interesting to know when the Chinese central government in Beijing will allow the yuan to become a free-floating currency. It doesn't, however, seem like that's going to happen in the short term, as there is too big a fear among Chinese policymakers that a freely floating exchange rate could trigger turmoil in the currency markets.  

But analysts say having a freely traded currency in the long run is in China's own interest. "China is in the midst of restructuring its economy and shifting away from an export-reliant growth model to one driven by domestic consumption," Vöpel underlined, adding that an appreciation in the value of the yuan will help the new economic model.

The path to achieve full convertibility of the currency will take around 10 to 15 years, the economist noted.