China joins IMF currency basket: Why it matters

BEIJING - The addition of China's yuan to the select basket of currencies used as a yardstick by the International Monetary Fund is a sign, experts say, that the yuan may one day become as recognizable as the dollar or euro.

Adding the yuan alongside the dollar, euro, pound and yen is a symbolic victory for Beijing. It reflects the rising importance of the world's second-largest economy and is an endorsement of gradual Chinese moves toward making the currency freely traded.

Currency traders and economists see the change as encouragement to Beijing to make faster progress on promises to make the yuan "freely tradable" and open its financial system.

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WHAT HAPPENED

The IMF added the yuan to the basket of currencies used to calculate the value of Special Drawing Rights, a notional currency used as the standard for dealing with its member governments. That came after IMF staff concluded in a Nov. 13 report that the yuan was "freely usable," meaning widely used for international transactions and widely traded in foreign exchange markets. The IMF created SDRs in the 1960s as a possible international currency, but they failed to gain wider acceptance. Until 1980, the basket was 16 currencies including Iran and South Africa but that was reduced. Following the global financial crisis, Beijing called in March 2009 for creation of a new currency, possibly based on the SDR, to reduce reliance on dollars but failed to attract support.

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WHY ADD THE YUAN?

China is the second-biggest economy after the United States and the biggest trader. The yuan is the No. 4 currency for global trade, accounting for about 2.5 percent of the total, according to SWIFT, the organization for interbank financial transfers. Beijing controls the flow of money into and out of its economy but has encouraged the use of the yuan abroad, especially for trade, which helps Chinese exporters by eliminating the cost and risk of volatile exchange rates. Since 2009, China has signed currency swap agreements with central banks in Britain, Brazil, Canada, Indonesia, South Korea and other countries. Branches of Chinese state-owned banks in Britain, Australia, Germany, Switzerland, Russia, France and Singapore have received authorization to take deposits or settle trade-related transactions in yuan.

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IMPACT ON GLOBAL FINANCE

The SDR has no direct link to financial markets or private business. Over time, the IMF decision might prompt central banks to hold more reserves in yuan. JP Morgan economist Haibin Zhu said yuan holdings might rise to 5 percent of global reserves, or about $350 billion, over five years. That might encourage more use of yuan for trade and investment. "Longer term, this is a huge step," said Stephen Innes, chief trader for the currency firm OANDA in Singapore. "Once investors become more comfortable with Chinese markets, especially if they continue to progress with opening policies and make the same strides they did over the past year, international markets will really embrace Chinese capital markets."

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IMPACT ON CHINA

Economists say the IMF decision could encourage Chinese leaders to further relax controls on the yuan. The ruling Communist Party's latest five-year development plan says the yuan will be "freely tradable and freely usable" by 2020. The surprise August introduction of a new mechanism for setting the government-controlled exchange rate led to a 3.5 percent devaluation. But the country's top economic official, Premier Li Keqiang, said in September that there were no plans for further declines. Some traders worry Beijing might devalue once it achieved its goal of being added to the IMF basket. But others say Chinese leaders want to be seen as reliable. The yuan's addition is "an endorsement as an international currency," said Chen Kang, chief bond analyst for SWS Research Co. in Shanghai. "That will encourage China to adopt more measures toward accelerating the process of the opening of its foreign exchange markets and capital markets."

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UNINTENDED CONSEQUENCES

The yuan's government-set exchange rate still follows the dollar despite the new mechanism for setting its value. For now, that makes the yuan a dollar in disguise, according to Derek Scissors of the American Enterprise Institute in Washington. Until the yuan is allowed to trade freely, the IMF decision will "increase the dollar's importance," said Scissors in an email. "Those governments or investors hoping for a dilution of dollar dominance for portfolio diversification or political reasons are getting exactly the opposite."