Is the world to get a new reserve currency?

The Special Drawing Rights reserve asset is based upon the values of 4 major currencies: GBP, EUR, USD and JPY. This exclusive group of currencies has heretofore enjoyed status as the world’s official reserve currencies. Now, another currency is likely to join the ranks and it is none other than the Chinese yuan – CNY. IMF representatives have intimated that China will likely become the fifth in a basket of currencies with SDRs.

How will SDRs affect the CNY?
SDRs afford each of the member countries the right to draw any of the required currencies in the basket in order to meet the needs of their balance of payments. Each of the four currencies in the SDR is weighted according to specific requirements. For example, in August, the United States reported that it had approximately $50 bln in SDR holdings. In September 2015, an equivalent value of some $280 bln in SDRs was disseminated to IMF members. The Chinese government is particularly fond of the idea that it is now being included as part of the elite group of currencies with SDR status.
This is important given the massive global uncertainty that has rocked the markets since 2009. At critical junctures like that, the global monetary system is heavily reliant on currencies like the USD. Now that China holds the official status as the #2 economy in the world, it is befitting for the Asian giant to be included in this elite club. For China there is a degree of prestige involved in this latest decision. That China has been invited, and endorsed by several countries to join the IMF’s SDR is a notable achievement. This is being hailed by some as a just reward for moving towards a more market-based economic system. Despite the fact that the CNY was rejected for inclusion in the SDR in 2010, the widespread usage of this currency has surged in the five years since. As at August, a total of 2.79% of all global payments processing was conducted with this currency. That places the CNY above the JPY.
The Chinese government has rejected the use of SWIFT for money transfer purposes. This cross-border payment system is responsible for handling most of the world’s payments transfers, but China uses its own system known as CIPS (China International Payment System). The Chinese cross-border CNY payments transfer system is modelled after the US Clearing House Payment system, and the reason why China established its own is because it doesn’t want to use Western-based ones. In the event that sanctions are imposed on China, it wants to be in control of the money payments system – not to leave it in the hands of Western countries.
The IMF makes use of several measures to determine how freely usable a particular currency is. This is how it determines a currency’s eligibility for inclusion in the SDR. There have been reports by members of IMF committee stating that the Chinese yuan is lagging many other currencies in terms of currency trading, forex reserves and debt holdings. However, the executive directors of the IMF will be the ones making the final decision as to whether to include the CNY as part of the IMF’s SDRs. Just recently, the Chinese premier travelled to London to agree to a multibillion pound deal between China and the UK. This will cover multiple sectors (150 companies) such as aircraft manufacturing, cars and others. China is increasingly moving towards enhanced relations with the UK, and this bodes well for the currency.
The world’s most successful economies including the UK, the US, Germany, France and others see no reason not to endorse the Chinese renminbi provided it meets all of the requirements as set out by the IMF. By including China as part of the fund, a major component of the global economy now has representation in an elite club. What is likely to happen as a result of this pending decision is a migration of $1 trln in global financial reserves to China. This has been laid out by the management at AXA Investment and Standard Chartered Plc. As soon as the CNY joins ranks with the SDR, managers of central banks the world over will be looking to rack up as many CNY-denominated asset holdings as possible. From its perspective, China will do well to welcome as many different issuers as possible in the Chinese onshore market.

What tests does China need to pass?
When the IMF holds its official meeting in November, the issue of China’s admission will come to the fore. There are, however, several criteria that need to be met before China gains acceptance to the SDR. These include the CNY being a freely usable currency – no problems there, and China must be a major trading country – no problems there either. The Chinese are not idly sitting around waiting for the IMF decision without taking action into their own hands. China has now opened up its bond markets to foreigners with what is known as the Panda bond market. By 2020, this could be worth as much as $50 bln according to analysts.
The fact that the Chinese government is seeking greater transparency in its business dealings is certainly helping it to gain approval with the IMF. A freely-floating exchange rate is also warmly welcomed by the US, UK, Germany and Japan. That’s precisely what the Chinese are allowing vis-a-vis demand/supply of their currency. Other economic data released by China such as gold reserves, forex holdings, PMI, GDP and the like are further evidence of China’s move towards a more market-based economy with greater transparency of economic data.

Please note that this column does not constitute financial advice.