On 30 November, the executive board of IMF voted to add China’s currency Renminbi to the Special Drawing Rights (SDR) basket. It included Renminbi into the “basket of currencies” that make up the value of special drawing rights (SDRs). Currently, there are four currencies in the basket- US dollar, UK pound, European Euro and Japanese Yen. The change will be effected from October 1, 2016.
The value of SDR is derived from the weighted average of the value of currencies in the basket. IMF conducts a 5-yearly review of the composition of the basket. In this year’s review, it added China’s currency Renminbi in the basket.The weights of the currencies following the change will be 41.73% for U.S. dollar, 30.93% for Euro, 10.92% for Chinese renminbi, 8.33 % for Japanese yen, and 8.09 % for Pound sterling.
There are two criteria for a country’s currency to be included in the basket:
1. The country must be a major exporter.
2. The currency is freely usable. It implies that it must be widely used in international transactions and the value of the currency should be market determined.
China reformed its economy to enable its currency to be considered for inclusion in the basket. It also devalued Renminbi by 4.4% against the dollar and let the market have more control in the determination of exchange rate. IMF chief Christine Lagarde said, “ Yuan’s inclusion is a clear representation of the reforms in China.”
Before going into the repercussions of this decision, let us have a basic understanding of SDRs.
Fixed exchange rate system was established by the Breton woods twins (IMF and World Bank) in the 1940s. Countries had to use gold or US dollars (which were convertible to Gold) to buy its local currencies in the foreign exchange (FOREX) market to maintain the fixed exchange rate. But, the supply of gold and dollars was limited. IMF created SDR in the year 1969 to be used as an international reserve asset. But, two years after SDR was formed, the fixed exchange rate system collapsed and gave way to floating exchange rate system. The importance of SDRs declined. But, during the financial crisis of 2008, it was used to supplement reserves of the IMF member countries.
IMF member countries are allocated SDRs in proportion to the monetary contribution (also called IMF quota) they make to the IMF. SDR is not a currency nor a claim on the IMF. Holders of SDRs can exchange them for currencies that make up the SDR basket. Special Drawing Rights are also used as a unit of account by the IMF and some other international organisations.
The inclusion of Yuan is the biggest change in SDR since Euro was added in 1999. Though SDRs are not that important part of the world economy, this decision is hugely symbolic. China is the first developing country to get this status. The main advantage of the move to China is that it could give a boost to the attractiveness of Renminbi as a reserve currency. Renminbi will play a larger role in International trade. It will be used as means of international payment.Foreign central banks will use Renminbi as part of their foreign exchange reserves to help in unforeseen circumstances.
The main disadvantage for China is that it could limit its ability to manipulate its currency. It will add the element of uncertainty to the economy due to volatility in the exchange rate.
That is all for the inclusion of Yuan/ Renminbi into the currency basket. The addition of yuan is the acknowledgment of the growing economic clout of China by the IMF. It also makes SDR more representative of the present world economy.