OREANDA-NEWS. October 03, 2016. IMF is adding the Chinese renminbi (RMB) to the basket of currencies that make up the Special Drawing Right, or SDR.

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The SDR is an international reserve asset created by the IMF in 1969 to supplement its member countries’ official reserves. The IMF’s Executive Board agreed to change the SDR’s basket currency composition in November 2015, and the decision now enters into force after a period of transition. The RMB joins the SDR basket in addition to the previously included four currencies—the U.S. dollar, the euro, the Japanese yen, and the British pound (see chart).

In an interview, Siddharth Tiwari (Director of the IMF’s Strategy, Policy, and Review Department) and Andrew Tweedie (Director of the IMF’s Finance Department) explain why this change took place and its significance for the IMF, the SDR, China, and the international monetary system as a whole.

IMF News: What does the renminbi’s inclusion in the SDR basket mean for China?

Tiwari : The RMB’s inclusion is an important milestone in the integration of the Chinese economy into the global financial system. The IMF’s determination that the RMB is freely usable reflects China’s expanding role in global trade and the substantial increase in the international use and trading of the renminbi. It also recognizes the progress made in reforms to China’s monetary, foreign exchange, and financial systems and acknowledges the advances made in liberalizing, integrating, and improving the infrastructure of its financial markets. We expect that the inclusion of the RMB in the SDR basket will further support the already increasing use and trading of the RMB internationally.

In addition, while data disclosure is not a formal criterion for a currency’s inclusion in the SDR basket, issuers of reserve currencies generally meet high transparency standards. The Chinese authorities have recently taken welcome steps to increase data disclosure and enhance their commitment to multilateral data initiatives; for instance, reporting the currency composition of reserves to the IMF. Also, the Chinese authorities continue to work with the Bank for International Settlements on their reporting of the Chinese banking sector statistics. These developments will lead to increased acceptance of the RMB among official holders of foreign exchange reserves.

IMF News: Stepping back a bit, what are the criteria for inclusion in the SDR?

Tweedie : There are two main criteria for a currency to be included in the SDR basket.

The first is the export criterion, which requires that the currencies in the basket be issued by the top exporters of the world. It has been part of the SDR methodology since the 1970s and it aims to ensure that the currencies that qualify for the basket are those issued by members or currency unions that play a central role in the global economy.

The second is the requirement for currencies in the SDR basket to be determined by the Fund to be “freely usable”—that is, widely used to make payments for international transactions and widely traded in the principal exchange markets. This criterion became part of the SDR methodology in 2000 to capture the importance of financial transactions in the global economy.

IMF News: How is the renminbi’s inclusion expected to impact the international monetary system?

Tiwari : There are several benefits to the international monetary system.

First, the inclusion of the RMB in the SDR basket consolidates the RMB’s internationalization process. The internationalization of a currency imposes strong requirements on its markets and institutions. Experience shows that some of these elements include developing deep and liquid financial markets, achieving a certain degree of openness of the capital account, delivering predictable macroeconomic outcomes, strong and credible institutions, and securing the integrity of the markets—for example, by putting in place a reliable rule of law. Thus, consolidating and further strengthening the RMB internationalization process will help strengthen the Chinese economy, and therefore the global economy.

Second, the inclusion of the RMB in the SDR basket enhances the attractiveness of the RMB as an international reserve asset. This will help with the diversification of global reserve assets.

What motivated the change in the SDR basket?

The IMF Executive Board’s decision to include the RMB as of October 1 was taken in the context of the Review of the Method of Valuation of the SDR, which takes place every five years. These reviews typically evaluate the selection criteria for the currencies that should be part of the basket, the selection of currencies, the weighting methodology, and the composition of the basket. Broader issues related to the role of the SDR in the international monetary system and SDR allocation are outside the remit of this review. The SDR valuation framework aims at supporting the SDR as an international reserve asset.

The conclusions of 2010 SDR valuation review, subsequent discussions by the Board in 2011—which ratified that the criteria for inclusion of a currency in the SDR basket should remain unchanged—and the increasing importance of the Chinese economy determined that the 2015 review should focus on the building blocks relevant for the determination of whether to include the RMB in the basket.

“Staff’s thorough analysis—a significant cross-departmental effort to examine complex issues given the development of financial markets—allowed the Executive Board to conclude that the RMB can now be considered widely used and widely traded (according to the definition of a freely usable currency set forth in the IMF’s Articles of Agreement),” said Siddharth Tiwari, Director of the IMF’s Strategy, Policy, and Review Department.

IMF News: How will this change affect the SDR itself?

Tweedie : The RMB’s inclusion is not just an important milestone for China, but also for the SDR itself. This is the first time that a new currency has been added to the basket since the euro replaced the French franc and the Deutsche mark in 1999. The RMB’s inclusion further diversifies the SDR basket and makes its composition more representative of the world’s major currencies. As such, the inclusion is expected to enhance the attractiveness of the SDR as an international reserve asset.

IMF News: So far we have discussed the implications of the RMB’s inclusion for China, the SDR, and the international monetary system. But how does this affect the Fund?

Tweedie : The determination that the RMB is freely usable changes China’s rights and obligations vis-?-vis the IMF and has important implications for the Fund’s financial operations.

When selected to participate in Fund transactions, issuers of freely usable currencies are expected to provide their own currency in purchases (i.e., Fund lending), and receive their own currency from borrowers in repurchases (i.e., repayments to the Fund). This means that, going forward when China is selected, a borrowing member would receive RMB and would need to repay in RMB. If these borrowers ask China to exchange the RMB into another freely usable currency, China would be obliged to collaborate and make its best efforts to assist in the exchange of its currency into another freely usable currency, as is the case with other freely usable currency issuers. In contrast, when other members whose currencies are not determined by the Fund to be freely usable provide resources in Fund financial operations, they are obliged to exchange their currencies for a freely usable currency.

In addition, currencies in the SDR basket should have suitable exchange rates for SDR valuation purposes and a suitable reference interest rate. IMF member countries, their agents, and other SDR holders need to have adequate access to instruments denominated in freely usable currencies for reserve management purposes and for hedging risks.