Wednesday, March 02, 2011

G-20 Meeting Renews Talk of Including Chinese Yuan in SDR Basket

Wall Street Journal: Sarkozy Proposes Bigger Role for Yuan
Bloomberg: IMF Chief Urges Changes to Monetary System, Advocates Adding Yuan to SDR's Basket
Morningstar: IMF's Strauss-Kahn Wants the Yuan in SDR

Upon assuming the presidency of the G-20 this year, French President Nicolas Sarkozy stated that one of the issues he would put at the forefront of the G-20’s agenda would be the reform of the international monetary system. Heading into the G-20’s meeting last week, President Sarkozy mentioned that such reform should involve the inclusion of China’s currency, the yuan, in the basket of currencies that underlie the value of the International Monetary Fund’s (IMF) synthetic currency, the Special Drawing Right (SDR).

The IMF created the SDR in 1969 to serve as an additional reserve asset that countries could use to purchase foreign currencies. The SDR derives its value from the values of a basket of currencies. The currencies that currently comprise the basket are the U.S. dollar, the British pound, the Japanese yen, and the euro. However, President Sarkozy and other leaders, including the director of the IMF, Dominique Strauss-Kahn, have expressed their support to include the yuan in the basket of currencies.

A call for the yuan’s inclusion in the SDR basket reflects the growing importance of China in the global economy. The composition of the SDR basket is meant to reflect the currencies of the most important and active economies in the world. Therefore, it makes sense to include the yuan in the basket, since recent estimates have indicated that China is the third most active country in the global economy, as measured by the total amount of its exports.

This is not the first time that there has been talk of including the yuan in the SDR basket. When the IMF last reviewed the SDR basket in 2010, it considered the possibility of including the yuan. However, despite of China’s important role in the global economy, the IMF stated that the yuan remains ineligible for inclusion in the SDR basket because it fails to meet the criteria for inclusion, namely the requirement that the currency be “fully convertible.” Convertibility refers to the ease with which one nation’s currency can be exchanged (or “converted”) for another currency. Currently, China prevents such convertibility by restricting the ability of yuan-holders to send yuan across China’s borders. If a Chinese citizen, or any other holder of yuan, wishes to send currency abroad, that person must either first exchange yuan for the target currency, or obtain permission from the Central Bank of China to send yuan directly to the foreign destination. China has relaxed this policy when it comes to the trade of goods and services, but has maintained it for all other (i.e. capital account) transactions. The IMF’s charter allows nations to place restrictions on capital account transactions. However, as a practical matter, for a nation’s currency to be considered a reserve asset worthy of inclusion in the SDR, it must have the ability to be widely used, which requires full convertibility for capital account transactions.

China’s decision to exercise such control over the use of the yuan is part of its strategy to keep the exchange rate of the yuan loosely pegged against other currencies. China’s trading partners (especially the U.S.) have criticized China’s practice of managing the yuan’s exchange rate because they argue it causes the yuan to be artificially undervalued, which, results in China being able to maintain persistently large trade surpluses. However, if China were to allow free movement of the yuan for capital account transactions, it would put itself at risk for potentially volatile capital inflows and outflows. Thus, If China moved towards capital account convertibility, it would almost necessarily require China to loosen its control over the rate of the yuan, since the currency flows associated capital account freedom would make it unwieldy for China to keep the yuan's rate steady. Thus, the inclusion of the yuan in the SDR basket would not only make the basket more representative of the most important countries in the global economy, but it could also lead to a free exchange rate regime for the yuan and, consequently, an appreciation in the yuan and a balancing of trade levels. Indeed, many think that President Sarkozy’s call to include the yuan in the SDR basket is an indirect way to get China to abandon its controversial practice of controlling the value of the yuan. Whether China decides to do so remains to be seen.

Discussion Questions:
1.) If calls for the yuan’s inclusion in the SDR’s basket reflect China’s greater importance in the world economy, should the U.S. be concerned about being replaced as the world’s economic superpower? If so, is this inevitable, or is there something the U.S. can do to prevent it from happening?
2.) The U.S. dollar is currently the predominant reserve asset held by countries across the world. Does the renewed focus on the SDR signal that it may replace the dollar as the world’s primary reserve asset? Should the U.S. be concerned about this too?

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