It’s a club reserved for the world’s elite economies…
Created in 1969, the International Monetary Fund Special Drawing Rights (SDRs) is an international reserve asset that’s intended to supplement member countries’ reserves.
Its value is based on the value of four key currencies – the U.S. dollar, the euro, the Japanese yen, and the British pound.
Well, guess who’s pounding on the IMF’s door, looking to gain access to this exclusive club of high rollers?
China.
Now boasting the world’s second-largest economy, the country wants its yuan currency to be elevated to reserve status.
What are the odds of this happening?
Two Tests… Two Passes
Needless to say, the jury is still out. But there are increasing signs that point to the yuan’s admission when the IMF meets in November.
The IMF has two major criteria for admission into the club:
The country must be a major trading nation. Suffice it to say, China easily passes this test.
The currency must be “freely usable.” China is passing this test, too. In fact, it recently passed the yen as the world’s fourth most-used payment currency and it’s rapidly closing in on the pound in third place. (The dollar and euro occupy the top two spots, of course.) Over 1,000 banks in 100 countries now use the yuan for payments with China – up 20% over the past two years. As Chris Knight of Standard Chartered Bank told The Wall Street Journal, “Trading [in yuan] was almost nonexistent five years ago but today ranks amongst the most traded currencies globally.”
In addition to passing these two crucial tests, China is proactively making moves to boost the yuan’s chances of inclusion in the IMF club.
For example, it’s expanded the part of its bond market that’s open to foreigners. This is important, given that the so-called “panda” bond market is expanding. Panda bonds are those issued by foreign companies, but denominated in yuan. The World Bank’s International Finance Corp. says this market could top $50 billion within five years.
But there are two other crucial moves that most observers will identify with…
First, China is becoming more transparent with its economic statistics, such as the amount of gold reserves and foreign currency reserves it holds.
And second, the central bank is making all the right noises about letting “demand and supply determine the exchange rate” of its currency.
The question is: given its ideological standoff with the West, how will China facilitate more yuan transactions?
China Says “No” to SWIFT
On October 8, China launched its own cross-border yuan payments system. Currently, most global payments are handled by Swift – the Society for Worldwide Interbank Financial Telecommunication.
However, the new and streamlined China International Payments System (CIPS) will replace the current jumbled system for making yuan transactions, which involves using a limited number of offshore banks that recycle the money back into China.
CIPS is modeled on the U.S. Clearing House International Payment System, which handles roughly $1.5 trillion in transactions daily.
But China has another motive for setting up its own system. Swift is controlled by Western banks. When sanctions threatened to cut off Russia from Swift, one of its top bankers said it was the equivalent of a declaration of war.
There also have been numerous allegation that U.S. spy agencies have access to Swift.
China wants no part of this, and there’s a strong chance that when CIPS is up and running smoothly, Russia and a number of other countries will dump Swift.
The Likely Outcome
I believe China’s currency will gain inclusion into the IMF SDRs at the next meeting (although there’s a possibility of the vote being put off until early next year). Why?
Well, while there’s no doubt that the United States is against its inclusion, its power is limited. China needs to gain 70% approval from IMF shareholders… but Uncle Sam only has a voting share of 16.7%, so it can’t block China’s entry.
Plus, it’s unlikely that the Americans want to repeat the embarrassment of its opposition to the China-led Asian Infrastructure Investment Bank (AIIB). Despite its opposition, most U.S. allies joined the AIIB anyway.
For the Chinese government, getting the yuan into the IMF’s exclusive currency club will be welcome news, given the capital outflows out of its currency this year. In fact, Standard Chartered (L:STAN) estimates that IMF inclusion could trigger $1 trillion of inflows into the yuan, as central banks add the currency to their reserves.
We could just be a few weeks away from a major development in the currency market, as the yuan gets set to enter the stage as a global currency powerhouse.
Good investing,