The IMF (International Monetary Fund) created the SDR (Special Drawing Rights) fund in 1969 to address liquidity issues. Back then, according to the Bretton Woods agreement of the fixed exchange rates system, all of the countries pegged their currencies to the US dollar. However, this meant that the US would persistently run on current account deficits as countries increased their dollar reserves. This was a threat to the US dollar. It led to the creation of the SDR.
As a result, the SDR is a supplementary reserve asset. It can be used to bolster a country’s reserve holdings. Accordingly, it gives IMF member countries the right to procure any of the currencies in the basket from the fund to meet their balance of payment requirements.
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The IMF reviews the composition of the SDR basket every five years. The IMF rejected the yuan during its last review in 2010. It didn’t meet the eligibility criteria. The last change in the IMF’s SDR basket was in 1999. At that time, the euro replaced the German deutsche mark and the French franc.
China (FXI) (YINN) (ASHR) will be the first emerging market (EEM) (EMB) economy to get a place in the SDR basket for its currency. Interestingly, its per capita income is about one-fourth of the other reserve currency economies like the US, Europe, the United Kingdom, and Japan.
The decision will be put into effect on October 1, 2016. China’s currency will have a 10.9% weight in the SDR basket. This tops the 8.3% weight commanded by the Japanese yen and the 8.1% commanded by the British pound. The US dollar would command a 41.7% share. It’s followed by the euro with a 30.9% weight.
Compared to the current weighting in the SDR basket, the US dollar’s weight would fall by 0.4%. The euro’s weight would fall by 17.3%. The yen and the pound would fall by 11.4% and 28.4%.
In the next part, we’ll discuss the importance of the reserve currency status to China’s economic and trade prospects.