image originally from www.eagle.co.ug By Kayleigh Yerdon, Summer 2015 Intern, Cornell University
On Friday, November 13th, the head of the International Monetary Fund (IMF), Christine Lagarde, gave the official green light for the Fund to accept China’s currency, the Yuan, as a reserve currency. Essentially, her recommendation to give the currency reserve status means that, if approved, the Yuan will become a “safe-haven” currency, or one that is held “in significant quantities by governments and institutions as a part of their foreign exchange reserves”. Currencies with reserve status are considered less likely to depreciate randomly or fluctuate greatly. In this case, the Yuan would stand alongside the US Dollar, the British Pound, the Japanese Yen and the Euro as one of the world’s strongest and most reliable and widely used currencies for international trade.
On November 30th, the board of the IMF will meet to decide whether or not to approve Lagarde’s recommendation and give the currency official reserve status. This would be the first currency added to the Special Drawing Rights basket – the reserve of IMF maintained assets used for foreign exchange – ever (since its creation in 1981). Basically, this could be a huge step for China; and we, as investors, are left wondering: what will happen if the IMF officially accepts the Yuan?
For starters, the acceptance of the Chinese Yuan as a hard currency would (at long last) imply a start to the re-stabilization of the Chinese economy. It is no secret that China, the world’s second largest economy, has recently dealt with great economic turmoil which led many economists and investors to question whether or not China's economy would collapse in late August of this year. Expert’s concern about sustained financial solvency earlier this year centered on positive economic results grounded in credit-driven booms, bubbles, and heightened consumer spending as the primary source of growth, among other things – all of which created economic volatility and instability. However, acceptance into the IMF as a reserve currency signifies the People’s Bank of China (the central bank) has committed to support and modify China’s financial system and to further open its markets to international investors – with a long-term goal of financial stability.
Furthermore, an additional and important benefit of acceptance into the IMF is that the people living in countries that issue reserve currencies can often purchase imports and borrow across borders more cheaply than people from countries without reserve currencies. This is due to the fact that most countries will keep a significant supply of reserve currencies as a measure of financial and foreign exchange stability, meaning that people who live in reserve-currency-issuing countries don’t need to exchange their currencies in order to trade. This reduces exchange risk for traders and makes international trade simpler. In China’s case, the acceptance of the Yuan could potentially stimulate the Chinese economy and the economies of the countries with which it trades.
In addition to the trade benefits, investors generally prefer investing in economies with hard currencies, as well – especially in times of great inflation or perceived risk – as they believe that these currencies are less likely to experience dramatic volatility. With IMF endorsement, Chinese investors may begin to feel more secure about investing both in China and abroad. Furthermore, many investors believe that inclusion into the Special Drawing Rights basket will “pave the way for foreign firms to sell bonds and shares in China” – possibly opening up global investing channels.
If approved on November 30th, the Yuan would not officially be included in the currency basket until October 2016 and the possible changes thereafter would be gradual. However, it’s always a good idea to look ahead and stay knowledgeable about the global markets, as changes like this could affect your investment portfolios.