Demand unlikely to boost yuan despite basket inclusion

The International Monetary Fund's decision to include the yuan in the Special Drawing Rights basket will not directly increase the demand for yuan assets. Also, the implicit endorsement of the yuan as a reserve asset is unlikely to sway the decisions of global asset managers. Indeed, China's market interventions this year in response to capital outflows and the bursting of the equity bubble provide strong reasons for them to steer well clear.

Much of the commentary on the IMF's decision has been marred by misunderstanding of the role the SDR performs. The SDR is the unit of account used within the IMF. Its value is determined as a weighted average of the basket currencies (currently the dollar, euro, yen and the pound sterling).

IMF members hold balances denominated in SDRs. If any of them encounter balance of payments strains they can sell SDRs to other members in exchange for any of the currencies in the basket. In this way, SDRs are a supplementary reserve asset, giving access to reserve currencies. In normal circumstances, though, there is no boost in the demand for a currency simply because it is in the SDR basket.

A second misconception is that membership of the basket determines "reserve currency status". On this basis neither the Australian nor the Canadian dollar would be reserve assets, although they each account for 1.9 percent of global reserves for which a currency breakdown is available.

In practice, what determines whether central banks are willing to consider a currency a reserve asset is their confidence that they can sell those assets whenever needed into deep and liquid markets. Inclusion in the SDR basket could be taken as endorsement by the IMF that the yuan and China's financial markets meet this standard. But central banks are likely to reach their own judgments.