Including the yuan in the SDR signals a shift in the global financial architecture

The IMF staff and management have recommended including the yuan in the Special Drawing Right (SDR) and it is very likely that the IMF Board will accept the recommendation at its scheduled meeting on November 30. To understand the significance of this decision it is important to keep four things in mind.

First, adding the yuan to the IMF’s currency basket indicates that the existing financial architecture can adjust to the economic rise of China and other emerging markets. The world has changed enormously since the Bretton Woods system was founded. Developing countries now make up about half the world economy. So institutions like the IMF need to change in order to stay relevant in today’s world. For a long time the SDR has consisted of four currencies: dollar, euro, yen, and pound. Now the Chinese yuan will join the basket. Of course other changes are needed as well, notably a shift of quota shares in the IMF towards the fast-growing developing economies. But this currency development shows that major reform is possible within the existing system.

Second, the inclusion of the yuan should be seen as an opportunity but not a guarantee that the Chinese currency will become a major reserve currency. The direct effect of inclusion is in fact small. IMF loans in the future will be partly disbursed in yuan, which is significant. But investors around the world will not automatically rebalance their portfolios because the yuan is now part of the SDR. Investors are more likely to take a look at the yuan, but investment decisions will be largely based on the reliability of yuan assets and prospective returns. There will not be a sudden big shift towards the yuan because of inclusion in the SDR.

Third, in the long run the attractiveness of yuan assets will depend to a large extent on the strength of the Chinese economy. After a long period of double-digit growth China is now facing a difficult transition to a new growth model that will depend less on very high rates of investment and more on productivity growth, especially in sectors that have lagged such as modern services. The 13th Five-Year Plan is an opportunity to move on needed reforms such as opening service sectors to international competition – that would apply to financial services, telecom, logistics, media, and healthcare, among others. Freeing up labor mobility through phase-out of the hukou system would also spur productivity growth and raise household income and consumption.

Fourth, completing the reform of the financial system would bolster growth and also directly contribute to the continued internationalization of the yuan. In holding foreign assets investors are influenced by the transparency and depth of capital markets. Government plans include moving to a system whereby firms that meet standards can go to the capital markets without needing government approvals. This would encourage more private firms – including eventually foreign firms—to list on Chinese markets.

There is still a significant agenda of economic and financial reform in China. Vigorously pursuing that agenda is in China’s interest, and will also have spillover benefits for the rest of world by spurring trade and investment and by further internationalization of the RMB. Historians may well look back and view this decision to include the yuan in the SDR as a milestone in China’s reform and opening up.

This piece was originally published by People’s Daily Online.