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Friday, October 23, 2015 1:32 PM

IMF Prepared to Bless Yuan As Reserve Currency; Reason to Celebrate? Any Real Significance?

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IMF Blessing Coming Up

Bloomberg reports IMF Said to Give China Strong Signs of Reserve-Currency Blessing.

The IMF has given Chinese officials strong signals in meetings that the yuan is likely to win inclusion in the current review of the Special Drawing Rights, the fund’s unit of account, said three people who asked not to be identified because the talks were private. Chinese officials are so confident of winning approval that they have begun preparing statements to celebrate the decision, according to two people.

At least $1 trillion of global reserves will convert to Chinese assets if the yuan joins the IMF’s reserve basket, according to Standard Chartered Plc and AXA Investment Managers.

While the SDR is not technically a currency, it gives IMF member countries who hold it the right to obtain any of the currencies in the basket to meet balance-of-payments needs. The equivalent of about $280 billion in SDRs were created and allocated to members as of September, compared with about $11.3 trillion in global reserve assets.

SDR status is significant as “a seal of approval” from the IMF that the yuan is indeed an internationalized currency, AXA analysts said in May. The yuan can get a potential weighting of about 13 percent, according to an estimate by Bank of America Merrill Lynch in March. HSBC Holdings Plc said in an April note that the yuan’s share could be 14 percent, reflecting China’s importance in global exports.
SDR Fact Sheet

Inquiring minds are investigating the IMF SDR Fact Sheet for more details and history on Special Drawing Rights.
The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. Holders of SDRs can obtain these currencies in exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges between members; and second, by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions. In addition to its role as a supplementary reserve asset, the SDR serves as the unit of account of the IMF and some other international organizations.

SDR Basket Definition

The value of the SDR was initially defined as equivalent to 0.888671 grams of fine gold—which, at the time, was also equivalent to one U.S. dollar. After the collapse of the Bretton Woods system in 1973, the SDR was redefined as a basket of currencies. Today the SDR basket consists of the euro, Japanese yen, pound sterling, and U.S. dollar. The value of the SDR in terms of the U.S. dollar is determined daily and posted on the IMF’s website. It is calculated as the sum of specific amounts of the four basket currencies valued in U.S. dollars, on the basis of exchange rates quoted at noon each day in the London market.

The basket composition is reviewed every five years by the Executive Board, or earlier if the IMF finds changed circumstances warrant an earlier review, to ensure that it reflects the relative importance of currencies in the world’s trading and financial systems.

SDR Interest Rate

The SDR interest rate provides the basis for calculating the interest charged to borrowing members, and the interest paid to members for the use of their resources for regular (non-concessional) IMF loans.

Buying and selling SDRs

IMF members often need to buy SDRs to discharge obligations to the IMF, or they may wish to sell SDRs in order to adjust the composition of their reserves. The IMF may act as an intermediary between members and prescribed holders to ensure that SDRs can be exchanged for freely usable currencies.
Role and Valuation of SDRs

The IMF makes loans in SDRs which in turn can be converted to other currencies. As of today, the total valuation is an equivalent valuation of about $280 billion.

The Basket of SDR Rates and Weights looks like this.

IMF Basket Math

I added the column in dark blue. If the Yuan were indeed to make up 13-14%, the percentages would adjust accordingly. But assume 14% and do the math.

14% of $280 billion is $39.2 Billion. Certainly nothing to get excited over.

I am not quite sure how Standard Chartered Plc and AXA Investment Managers concluded "At least $1 trillion of global reserves will convert to Chinese assets if the yuan joins the IMF’s reserve basket."

My guess is they assume that when the IMF puts the yuan in the SDR basket, countries will hold more yuan reserves outside of SDRs, a conclusion I certainly would not presume.

Global reserves total about $13 trillion in US dollar equivalents. $1 trillion of that would be about 7.69% of reserves. So even if countries started collecting yuan, we are still not talking about a huge portion of global reserves in yuan.

Yuan Peg Math

The Yuan is pegged to the dollar. As long as that peg is in place, one may as well keep dollars instead of yuan in reserves, assuming the exchange rate is steady.

But China recently devalued the yuan. It makes far more sense to hold dollars, not yuan, if one expects another devaluation.

Global Reserves

RankCountryOfficial Reserve Assets (in billions of U.S. dollars)
3Saudi Arabia$732.30
6Russian Federation$385.50
7Republic of Korea$363.60
9Hong Kong$328.50

The above Top 10 Global Reserve Countries from Investopedia.

The top 10 totals $8.6 trillion out of $13 trillion in reserves. The table is a bit out of date. For example, China's reserves are now estimated to be about $3.5 trillion.

It's important to realize that China accumulated those $3.5 trillion in reserves by running a trade surplus with other countries, over the years, heavily US weighted, to that approximate number.

Similarly, most of Japan's reserves represent the accumulated trade surplus Japan has with the US.

Does China have an accumulated trade deficit with the rest of the world to arrive at the $1 trillion reserve estimate of Standard Chartered Plc and AXA Investment Managers?

Mapping China's Balance of Trade

Foreign Policy Magazine does an excellent job of Mapping the World’s Winners and Losers from China Trade

The deeper the red the bigger the trade deficit. China has a big trade surplus with US, Canada, and most of Europe with the exception of Germany.

China has a January-July trade deficit with Germany of about $1.8 billion, $768 million with Japan, and $3.2 billion with Australia.

Accumulate such totals for 10 years and one does not come close to $1 trillion.

Reason to Celebrate?

The reason China celebrates is not because there is any real significance  to the IMF's move, but rather because China wants the prestige of being in the elite group of SDR reserve currencies.

SDR Concept Meaningless and Useless 

At $280 billion, SDRs have no global significance.

And since any currency is convertible to another instantaneously, at will, the notion of a "basket" as to having any significance is meaningless, regardless of the total!

People who discuss baskets of currencies overlook these obvious points, so expect to read a slew of nonsensical reports on the significance of this meaningless announcement.

Global Reserve Currency Discussion

The Yuan is not about to replace the US dollar as the world's reserve currency.

To become the world's reserve currency, a country needs the largest, most liquid bond market in the world, a freely floating currency, free markets, and likely a stable, freely elected government.

China does not come close to meeting any requirement needed to replace the US dollar as the world's reserve currency, let alone all of them.

Mike "Mish" Shedlock

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