Last week, the IMF announced that the yuan (also called the renminbi) would be part of the Special Drawing Rights (SDR) basket. There was no overwhelming reaction from markets, possibly because the OPEC and ECB meetings overshadowed the event, and because the move was expected.
However, there may be several long-term implications of the yuan's inclusion in the SDR basket.
The official fact sheet describes SDRs as "international reserve asset[s], created by the IMF in 1969 to supplement its member countries' official reserves". However, the SDR basket does not play as important a role today as it did a few decades ago, when the Bretton Woods system was in place.
Nevertheless, the yuan's inclusion in the basket sends a signal that the IMF believes China's currency has the same global standing as the other four currencies currently in the basket, which include the dollar, the euro, the sterling and the yen.
The Fund's managing director said the decision to include the yuan...
... 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.
How will this recognition affect the yuan? One of the requirements for a currency to be included in the SDR basket is that it should be "freely usable". After the announcement, the People's Bank of China stated it would allow the currency to be increasingly determined by market forces.
In the short term, this may lead to more volatility.
Some articles suggest the yuan may depreciate, as a more market-based currency would enable foreign investors who are worried about a "hard landing" to withdraw their funds more easily. In the near term, the yuan may also be overshadowed by the general gloom that is surrounding the emerging markets.
But this may not persist in the long run. The inclusion of the yuan in the SDR basket is likely to result in the currency becoming more international. This may encourage central banks around the world to increase their holdings of the yuan. A Bloomberg article suggests that the central banks of Korea, Philippines and Indonesia plan to increase their yuan reserves.
Other central banks may also take steps to build up their holdings of yuan to diversify their foreign exchange reserves. Moreover, the portfolios of global organizations, such as the World Bank, are linked to the SDR basket.
Just as the fund manager of an index fund needs to rebalance when the index adds a new stock, these portfolios will now invest in yuan-denominated assets when the SDR is updated.
The prospect of increased demand from central banks and investors may result in currency appreciation in the long term. If the currency does appreciate, it is likely to support the government's efforts in rebalancing the economy. The Chinese government has announced that it plans to reduce the economy's reliance on exports and investment and increase the contribution of consumption to economic growth.
A stronger yuan will encourage consumers to purchase foreign goods and shrink China's current account surplus. Over the last few years, the country has run large surpluses that have been blamed for causing global imbalances.
Furthermore, as the yuan is now officially recognized as a global reserve currency, China may attract more inflows from foreign investors, such as sovereign wealth funds, especially because of accommodative monetary policies in Europe and Japan. Higher foreign inflows may also lead to currency appreciation.
However, higher inflows may only materialize gradually. Global central banks do not need to increase their reserves just because the SDR basket has changed. Moreover, China's A-shares are still excluded from key global indices - to some extent, this stands in the way of foreign inflows.
There are still some reforms that need to be implemented before China increases its linkages with global markets. The PBOC's statement seems to indicate it will gradually relinquish its control of the yuan, but China also needs to include measures to liberalize the capital markets.
The IMF's press release included an expectation that the country would continue its financial and monetary reforms. The inclusion of the yuan in the SDR will hopefully be an incentive to policymakers to persist in reforms, and hence, the yuan to take on a more global role.