China goes even more global this weekend. Love 'em or hate 'em, on Saturday Oct. 1, the Chinese yuan joins the International Monetary Fund's currency basket. Once the yuan is a full fledged member of the IMF's Special Drawing Rights, it becomes a currency worth holding at every single emerging market central bank holding foreign currency reserves. That's a few billion yuan, on the low end, of demand for the Chinese currency...automatically.
Even though the yuan is not an immediate threat to the U.S. dollar's dominance in world trade, nor as a global reserve currency, the yuan's official entrance makes it the newest, liquid safe haven. Moreover, unlike the yen and the euro safe havens, this one actually has yield.
Last year, U.S. Treasury secretary Jack Lew said that the yuan was not ready for inclusion in the basket. His statement reflected similar sentiment in Washington, which has sought to roadblock China's moves within the multi-lateral institutions for years. The U.S. was against China's proposed Asian Infrastructure Investment Bank, and is one of the few Western powers that is not a member. China is also not a part of the Trans-Pacific Partnership, a proposed trade agreement between the U.S. and every other nation that shares a Pacific coastline except the one nation that buys and sells most with the United States.

With the yuan as a reserve currency, China suddenly becomes an integral part of the debate on where the global monetary system is heading. More importantly, Saturday marks China's receipt of a seal of approval that tells China's global trading partners (Brazil, all of Europe), including some that have riffs with the United States (Russia), that Beijing is serious about making the yuan a market currency used in trade settlement. The yuan is expected to replace the Great Britain pound and Japanese yen in trade settlement within the next few years, according to SWIFT.
It won't replace the dollar, but Asian nations that trade in commodities with the Chinese will increasingly price their goods in yuan.
Worth noting, emerging market fixed income funds love China's expansion in the currency markets because that expansion requires China to play by certain market rules. It is enticing China to open up, if not create from scratch a brand new bond market. Emerging market bond fund managers are only just starting to get their feet wet in Chinese bonds. At least three new exchange traded funds have been created to give retail investors a chance to hold yuans without opening up a Chinese bank account.
Impact & Implications
The IMF agreed, with Washington's blessing, to include the Chinese currency in the SDR basket on Nov. 30, 2015. The yuan joins the dollar, euro, yen and pound as part of the IMFs currency and has an initial weighting of 10.9%.
Central banks in the emerging markets -- those that hold nearly all of the world's foreign currency reserves -- are unlikely to rush to buy yuans. But there could be an indirect impact in yuan demand from central banks that are positioning in SDRs. Reserves at emerging market central banks are used to manage currency risk and as a back stop to foreign debt service, helping those markets achieve better credit ratings and ease foreign lender risk. Most of these banks hold dollars first, euros second. SDRs are weighted a little more than gold. Yuan, as an individual currency, is not usually weighted. But the IMFs endorsement here "supports long-term demand" for the yuan, say HSBC analysts led by Paul Mackel in Hong Kong in a report published Sept. 13.
"SDR inclusion should encourage further reforms on China's part to integrate its financial markets globally and push ahead with yuan internationalization," Mackel says.
As a reserve currency, China's aim is to be a source of diversification for Asian central banks who do not want to hold negative yielding euro debt, or a very weak Japanese yen. The yen has lost 24.3% of its value versus the dollar over the last five years. The yuan, which everyone insists is too weak, has lost just 4.2%.
The current uni-polar dollar system is not without its challenges. The advent of the euro took some of that away, but global trade is still heavily titled towards the greenback. When Brazil sells soybeans to the Chinese, its priced in dollars. The same holds for the Saudis selling oil to anyone, anywhere. China thinks that the yuan provides markets with another option. Why not buy Saudi oil in yuan? That's like IMF money for Saudi's central bank.
Lastly, the SDR inclusion has emerging market investment banks devising new products for investors to diversify into yuan denominated holdings. That will continue.
According to the People's Bank of China, foreign investors have increased their holdings of yuan-denominated debt by around 100 billion ($14.9 billion) between March and June alone. More timely data from the Chinese Central Depository and Clearing Co. suggests that foreigners were back to buying Chinese debt in August, which has kept the currency strong and irked short sellers waiting for the yuan to hit seven.
With the yuan totally global within the next 24 hours, look for Chinese local currency debt to be included in corporate and emerging market bond indices like the JP Morgan EMBI and the CEMBI indices. When that happens, the yuan will have even more support, if the base case scenario holds up rather than a hard landing.
"The challenges confronting the current U.S. dollar-centric system and its short comings are well known," says Mackel. "There is a structural shortage of risk free assets, namely Treasuries. The U.S. cannot provide a credible fiscal backstop to a stock of liabilities that is growing faster than its economy while maintaining confidence in the dollar," he says. "Financial market stress arises when the Fed tries to run a diverging monetary policy from the rest of the world...a very real prospect today."