Everything just changed for China's currency

The International Monetary Fund has officially designated the Chinese yuan a global reserve currency.

That means that it joins an elite group of currencies — the dollar, the yen, the euro and the pound — in the Special Drawing Rights (SDR) basket.

This doesn’t mean that money managers around the world will suddenly shift their holdings to yuan. But this new designation does send an important message about the yuan’s importance to the rest of the world.

To be included in this club a currency must be “freely usable,” “widely used,” and “widely traded,” according to the IMF. The organisation reported that the yuan met this criteria earlier this month.

According to the Society for Worldwide Interbank Financial Telecommunication, the yuan overtook the yen as the fourth most used currency for trade and settlement in August. It makes up about 3% of global trade.

In China this is a boost of confidence during a difficult year that has seen a yuan devaluation, two stock market crashes, and a slumping economy. After the devaluation in September, the Chinese vowed to maintain the yuan’s stability despite these economic factors.

Economic liberalization

It is also a win for those within the Chinese Communist Party that want to see the country’s economy liberalized, as Bloomberg economist Tom Orlick pointed out in a note Monday morning.

“…the yuan’s inclusion in the SDR basket is a win for China’s reformers — notably, for advocates of financial market opening at the People’s Bank of China,” he wrote.

“It should strengthen their hand to accelerate the modernization and opening agenda. In particular, that could mean further moves to open the capital account to cross-border flows.”

In the long term, this means everything for China’s economy. Here is Paul Mackel, HSBC’s head of global EM markets FX research, on the long term impact of the yuan becoming a reserve currency:

The significance of the RMB’s SDR inclusion goes beyond the potential impact of inflows into China. It would encourage China to stick to a much needed financial and capital account liberalization. These would over time increase financial sophistication and improve the efficiency of capital allocation, facilitating the shift to a more consumption and service driven economy. It should give China confidence in making its exchange change rate even more market driven, which would free up its monetary policy. The SDR marks an important milestone of RMB internationalization.”

It doesn’t change the situation on the ground right now, however.

Chinese corporations are still laden with debt, the economy is still slowing down, and the country still faces a negative demographic trend — the ageing of a massive workforce.

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