Defining the Yuan as 'Freely Usable'

December 1, 2015Currenciesby EW News Desk Team

0

The International Monetary Fund will begin using the yuan as a reserve currency.  The yuan weight will be 10.92 percent, after announcing that it sees the yuan as a “freely usable” currency, allowing it to join the euro, pound, yen, and U.S. dollar in the IMF’s Special Drawing Rights basket.

IMF Managing Director Christine Lagarde said in a press conference that the Chinese have reformed their economy to the point that its currency can be freely used in international trade. “The renminbi’s inclusion in the SDR is a clear indication of the reforms that have been implemented and will continue to be implemented and is a clear, stronger representation of the global economy,” Lagarde said.

Chinese policymakers have focused on making its currency a part of the SDR for decades. Critics note that this could weaken global demand for both U.S. dollars and U.S. Treasuries and weigh heavily on the U.S. dollar. That did not stop the U.S. dollar from gaining in trading after the IMF made its announcement.

Many analysts believe this will allow for international use of the yuan in global trade, and will help stabilize the U.S. dollar. The U.S. Treasury Department said in a statement that it supports the IMF’s decision.

The decision will also make foreign investment in China much easier, and may reduce the currency risk associated with such investments.

Avoiding Financial Fragility

The IMF’s move to include the yuan in its basket of reserve currencies will not only dilute the power of the U.S. dollar as the currency of international trade, but may also make international trade more robust and benefit smaller developing countries.

This, at least, constitutes the conclusion of a recent paper released by the IMF, which argues that higher capital flows between countries, combined with aggressive and unconventional monetary policies in developed countries, have created a more complicated monetary reality that requires a changing strategy.

Currently, the IMF paper argues, a reliance on a limited amount of currencies from developed markets (i.e., the U.S. dollar and euro) has led emerging markets to more boom and bust cycles.

"Also, in partially dollarized economies, credit growth, and to some extent consumption, can be driven by foreign interest rates independently of the domestic monetary policy stance. Inflows can also create currency mismatches with firms and banks borrowing in foreign currency,” the report said, adding that this "can increase financial fragility as a sudden reversal of inflows can lead to a large and disorderly depreciation of the local currency.”

The IMF’s proposed solution remains vague. Central banks may need to increasingly pay attention to financial stability issues stemming from these risks and develop the appropriate macro-prudential tools.