China achieved a significant economic milestone Monday, when the International Monetary Fund (IMF) added the renminbi (RMB) to its basket of reserve currencies, a move that is likely to result in financial reforms in the world’s second-biggest economy.

 

The Chinese currency, the renminbi (RMB), is to be included in the basket of currencies which make up the IMF’s Special Drawing Right, or SDR - "Renminbi" is the official name of the currency introduced by the Communist People's Republic of China in 1949 and it means "the people's currency" in Mandarin while "yuán" is the name of a unit of the renminbi. Something for example may cost one yuan or 10 yuán not 10 renminbi.

China and Japan share the same ¥ currency symbol and the Chinese character unit is pronounced yuán in Mandarin and en in standard Japanese. Koreans pronounce the same word as won and use symbol ₩.

Monday's move by the IMF was the first time in over 15 years that the list of currencies comprising the SDR has been altered. The change was agreed by the IMF’s executive board following a regular review of the currencies which make up the SDR basket.

The existing currencies are the US dollar, euro, pound sterling and Japanese yen. The reserve-currency basket will have a bigger weighting for China’s currency than to either the yen or pound. The basket is for denominating loans and it's not a tradeable asset. SDRs account for about 2% of global foreign reserves, of which the Chinese currency will have a 10.92% weighting, according to the IMF.

Nevertheless, the move is hugely symbolic.

"The executive board's decision to include the RMB in the SDR basket is an important milestone in the integration of the Chinese economy into the global financial system. It is also a recognition of the progress that the Chinese authorities have made in the past years in reforming China’s monetary and financial systems,” said Christine Lagarde, IMF managing director.

“The continuation and deepening of these efforts will bring about a more robust international monetary and financial system, which, in turn will support the growth and stability of China and the global economy,” she added.

China now accounts for more than 15% of the global gross economic output, almost triple what it was a decade ago.

Inclusion of the renminbi “means the international community expects China to play a more active role in global economy and finance,“ the People’s Bank of China (PBoC) said. ”China will speed up the effort to promote financial reforms and opening.”

“In terms of whether the renminbi will depreciate after its inclusion in SDR, there is no need for such a worry,” Yi Gang, a deputy governor at the PBoC, said at a news conference, according to the Wall Street Journal. Yi said China will maintain a “managed-float” system before it gradually transitions to a “clean float” of the yuán — a long-term goal that would mean the central bank stays out of trying to control the currency’s value.

The Financial Times said analysts and investors generally expect China to allow the renminbi to weaken gradually against the dollar over the coming months as a result of diverging monetary policies in the Chinese and US economies.

“It is a historic moment in international finance for an emerging market economy, with a per capita income barely a quarter that of other reserve currency economies, to be anointed as the issuer of one of the world’s major reserve currencies,” said Eswar Prasad, professor of economics at Cornell University and a former IMF China mission chief.

SDR: an international reserve asset

China renminbi reserve currencyThe SDR is an international reserve asset created by the IMF in 1969 to supplement its member countries’ official reserves. Since 1999, when the euro replaced the Deutsche mark and French franc, its value has been based on a basket of four currencies: the US dollar, the euro, the Japanese yen, and the British pound, that met the IMF’s inclusion criteria.

The composition and valuation of the SDR is typically reviewed every five years to ensure it reflects the relative importance of currencies in the global trading and financial systems.

The most recent review by the IMF’s executive board concluded that China and its currency met the two criteria for inclusion in the basket: that the issuing country is among the largest exporters in the world and that its currency is “freely usable.”

A currency is determined to be freely usable when it is widely used to make payments for international transactions and widely traded in the principal exchange markets. The IMF executive board’s determination that the RMB is freely usable and its decision to include the RMB in the SDR basket both take effect on October 1, 2016.

The review also acknowledged recent steps taken by the Chinese authorities to grant full access for official reserve managers and their agents to the onshore fixed-income and foreign exchange markets, as well as steps to enhance data disclosure.

SDR weights

The revised SDR basket will be based on the following weights: 41.73% for the US dollar; 30.93% for the euro; 10.92% for the Chinese RMB; 8.33% for the Japanese yen, and 8.09% for the British pound. These weights are derived from a new formula adopted by the IMF in this review.

According to this new formula, the weights of the currencies in the SDR basket are based on the value of the issuers’ exports, the amount of reserves denominated in the respective currencies that were held by other monetary authorities, foreign exchange turnover, and international bank liabilities and international debt securities denominated in the respective currencies.

IMF reflecting shifts in global economy

The decision to include the RMB in the makeup of the SDR basket reflects major shifts in the global economy, and is a recognition of China’s progress over the last few decades in moving toward a more open and market-based economy.

The IMF staff’s report to the executive board notes that since the last SDR review in 2010, the use of the RMB in international payments has risen substantially. In addition, renminbi trading activity in foreign exchange markets covering two of the three major trading time zones has increased significantly, and can now accommodate transactions of the magnitude involved in IMF operations.

These developments could herald future opportunities for a more stable and resilient global financial system. “As China’s integration continues and further deepens, and is paralleled in other emerging market economies, it could bring about a more robust international monetary and financial system which, in turn, would support the growth and stability of the global economy,” said Siddharth Tiwari, the IMF’s director of the Strategy, Policy and Review Department, .

IMF operations and the RMB

“The RMB’s inclusion will also enhance the attractiveness of the SDR as an international reserve asset by diversifying the basket and making the SDR more representative of the world’s major currencies,” said Andrew Tweedie, director of the IMF’s Finance Department.

As a freely usable currency, the RMB will play an important role in the Fund’s operations as, in practice, the bulk of the Fund’s lending activities takes place in freely usable currencies. The SDR interest rate, which forms the basis for the cost of borrowing from the IMF, will also include an RMB instrument starting in October.

The IMF says that authorities of all currencies represented in the SDR basket, which now includes China, are expected to maintain a policy framework that facilitates operations for the IMF, its membership, and other SDR users in their currencies.

Becoming one of the five currencies that back the International Monetary Fund's Special Drawing Rights is seen as an important symbolic step