The International Monetary Fund (IMF) in its review on 30 November 2015, made a long-awaited decision to include the Chinese Yuan in the basket of its elite reserve currencies which is used to calculate the value of the special drawing rights (SDRs). The Yuan, also known as the Renminbi, will join the US dollar, euro, Japanese yen and British pound next year from October 2016.
What are Special Drawing Rights (SDR)?
SDRs are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund (IMF). Their value is based on a basket of key international currencies reviewed by the IMF every five years.
SDR basket help countries defend against exchange rate fluctuations. After inclusion of the Yuan, the SDR will consist of five currencies viz., US dollar (41.73 percent weightage), euro (30.93), pound sterling (8.09), Japanese yen (8.33) and Chinese Yuan (10.92 percent).
The weightage assigned to each currency in the SDR basket are adjusted to take into account their current share in international trade and national foreign exchange reserves.
Reasons for Inclusion of Yuan in SDR Basket
• China is the world’s second largest economy and its share in global trade is rising.
• The inclusion of the Renminbi will enhance the attractiveness of the SDR by diversifying the basket and making it more representative.
• Due to various steps taken by the Chinese officials like relaxing controls on foreign institutional investors buying Chinese securities, easing restrictions on interest rates and the exchange rate, allowing capital to flow freely into and out of the just-launched Shanghai Free Trade Zone and efforts to develop China’s money and bond market.
• China now has five offshore Yuan trading centres viz., Hong Kong, London, Singapore, Taiwan and Sydney.
• In 2013, the Yuan overtook the euro as the world’s second-most used currency in traditional trade finance.
• Recently, HSBC estimated that the amount of bonds denominated in Yuan sold outside China has doubled each year since 2008.
Benefits to China and rest of the World
• It is recognition of China’s economic strength and its real role in the modern world.
• Reserve status will make global trade and financing cheaper for Chinese businesses. It will create better foundations for China’s macroeconomic management.
• It will give recognition to the ascendance of the Asian power in the global economy.
• Stability of the Yuan will benefit the BRICS nations significantly and hence reduce the currency risks.
• The exchange rate of Yuan will be relatively stable among the currencies of BRICS countries and is widely used in world trade and investment.
• Several countries like India have a trade deficit with China and need the Yuan; on the other hand, many countries in Africa have a trade surplus with China, and have been accumulating Yuan. Renminbi’s addition to SDR will allow these countries to trade in the currency market.
• However, on the flip side, with the inclusion of Yuan, Indian importers may be exposed to the RMB-INR exchange rate risk in the initial period.
Challenges before China
• China has just one year to make Yuan a genuine reserve currency. It has to lift all restrictions from free trade and make Yuan a freely convertible currency.
• A more long-term challenge for investors is that China’s political risks are bigger and different vis-a-vis liberal western democracies. It will be harder for Beijing to convince investors that its central bank is an independent institution.
• The lack of transparency and stability because of devaluation by authorities is another challenge for Yuan.
Where does the Indian rupee stand out?
India is also ambitious to increase the country’s clout on the international stage and to extend the reach of its currency by liberalising investment and trade norms.
Several steps have been taken by the RBI and the Government towards a freer rupee like allowing companies to raise rupee debt offshore, with “Masala Bonds”, and allowing foreign investors to invest more in rupee debt onshore.
However, concerns over broader economic stability in India mean there is little appetite for “big bang” currency reforms. With major structural reforms to make India competitive on a global scale are still at a nascent stage, it will take more than a decade for India to catch up in the currency race.
Every change comes with pros and cons. RMB inclusion in SDR should be viewed positively for china and rest of the world. Along with diversification; it will reduce dependence on other hard currencies like dollar and bring about more stability in the financial system.
Though dollar is still the major reserve currency and holds around 62 percent of the world’s aggregated reserve policymakers and investors should prepare for a world where the Yuan will play a mightier role.
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