Q: Is the IMF’s Inclusion of the Chinese Yuan in the Special Drawing Rights Basket a Reserve Currency Game Changer? A: No!

Today the International Monetary Fund (IMF) met economy watcher’s expectations and announced the inclusion of the Chinese yuan in the basket of currencies that make up the Special Drawing Right (SDR) units that the IMF uses in making loans. The yuan now joins the US dollar, euro, pound and yen as an “official” reserve currency – at least according to the IMF. At face value this sounds like a pretty great thing for the yuan and the obvious question is thus what are the implications for investors? The implications are, perhaps surprisingly, almost non-existent. Let us explain.

In order for a currency to be usable by outside investors, the currency must be 1) freely convertible and 2) the country of issuance must allow foreigners who have acquired the currency to purchase domestic assets. If either one of these two prerequisites are not met then the currency is basically useless to foreigners. In the case of the yuan, neither prerequisite is met…at least currently.

On the first point, the yuan is not a freely convertible currency in the traditional sense of the term. For example, holders of yuan inside of China cannot convert their yuan into US dollars and move it out of the country. Likewise, there is practically no secondary market for yuan trading outside of China. As a result, investors and companies cannot easily obtain yuan, making its usability extremely limited.

On point number two, foreigners (if they managed to obtain yuan) have to do something with it. That “something” is either to exchange those yuan for US dollars or some other hard asset – a difficult proposition given the point just discussed – or purchase Chinese assets (stocks, bonds, real estate). Currently, foreigners cannot easily purchase Chinese assets except through extremely convoluted means that are not available to everyone. Again, this feature of the Chinese management of their currency and balance of payments make usability of the yuan outside of China extremely limited.

So while the inclusion of the yuan into the SDR basket is a nice political accomplishment for the Chinese government, the broader immediate implications are basically nill. In order for the yuan to become a reserve currency in the practical sense of word, the China must allow the yuan to be a freely converted and traded currency and it also must open its capital account so that money can easily flow into and out of China. These, at least, are the minimum requirements.