China Realizes IMF Goal; What’s Next?

After months of speculation, the Chinese yuan is now officially part of the International Monetary Fund’s benchmark currency basket, elevating it to reserve currency status.

Chinese monetary policy has focused on gaining entry into this elite club for the last year or so. With its membership safely secure, it raises an interesting question.

What’s next?

The IMF announced the yuan’s inclusion in the Special Drawing Rights (SDR) basket Monday. The New York Times called it a “milestone decision,” underscoring the significance of the move in terms China’s growing power on the world economic stage:

The move will help pave the way for broader use of the yuan in trade and finance, securing China’s standing as a global economic power… The IMF designation…bestows global importance. Many central banks follow this benchmark in measuring their reserves, which countries hold to help protect their economies in times of trouble. By adding the yuan to this group, the IMF effectively says that it considers the currency to be safe, reliable and freely usable.”

The SDR basket was created in 1969 to increase global liquidity. IMF member countries can use any of the currencies in the basket in order to meet balance-of-payment needs. The yuan joins the US dollar, euro, yen, and British pound in this elite currency club.

This is the first significant change in the SDR since the IMF abandoned the gold drawing rights basket in 1973. The only other change came in 1999, and was more technical than substantive, with the euro replacing the German mark and French franc.

China has been driving for inclusion in the SDR for some time as part of its long-term goal of reducing its dependence on the US dollar. With that goal reached, it can now look ahead to the next step in its overall strategic plan.

China has aggressively added to its gold reserves as part of that push. China has steadily increased its holdings of the precious metal since announcing the extent of its reserves earlier this year. Just this week, the Chinese central bank confirmed it added nearly 14 more tons of gold to its stash in October.

It is likely China has even more gold than it officially admits. As James Rickards points out on Mises Daily, many speculate that China keeps several thousand tons of gold “off the books” in a separate entity called the State Administration for Foreign Exchange (SAFE).

China’s sudden willingness to report at least a portion of its gold holdings last summer was clearly part of its strategy to gain inclusion in the SDR basket, but there could be other factors at play in its push for gold. As Peter Schiff pointed out on RT’s Boom Bust earlier this month, the IMF decision is another step toward China surpassing the United States as an economic power. Ultimately, China could un-peg from the dollar and back the yuan with its increasing gold reserve:

I don’t think [IMF inclusion] is going to have an immediate impact, but I think it is a step in the direction in which China has been headed. And that is to make the yuan a reserve currency, and ultimately potentially to be a replacement for the US dollar, especially if they have the good sense to back up their currency with their enormous gold reserves, which I think China is deliberately underreporting. I think they are accumulating more and more gold quietly and maybe secretly, because I do think that ultimately that is their intention – to have a gold backed yuan become the predominant currency in the world.”

In August, the Chinese devalued the yuan to a level of about 6.4-to-1. Rickard called it a “shot heard round the world.”

The devaluation led directly to meltdowns in US equity markets as the resulting strong dollar threatened to hurt US exports and jobs. A stronger dollar also hurts earnings of US companies with overseas operations. This damage has since become apparent in third-quarter corporate earnings reports. From China’s perspective, the devaluation was a step in the direction of an open capital account. But from the world’s perspective, it was a continuation of the currency wars. Investors saw more devaluations coming and more damage to US corporate earnings.”

If a simple devaluation caused rumblings, a Chinese move to un-peg the yuan from the dollar could set off an earthquake. Peter said he believes this is inevitable:

When the Chinese decide to abandon their peg both for the Hong Kong dollar and the yuan – that is going to be a 10.0 on the Richter scale of economic activity. That is going to be huge. This time, it’s going to be the dollar that takes it on the chin.”

In an interview with CNBC last spring, Rickard argued that the ability of the US to block inclusion in the IMF basket was constraining Chinese monetary policy.

They want the yuan in the SDR. But the US can block it. So the US is kind of saying to China, ‘Hey, you guys need to be on your best behavior. Keep that peg. Keep that dollar-yuan peg.’”

With that axe no longer hanging over their heads, it will be interesting to see how the Chinese move forward over the next year.

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