Why Adding China to the SDR Basket is Part of the Currency War

China cut the central bank interest rate last week.

For the sixth time this year.

In addition, the Middle Kingdom lowered the amount of cash banks must keep in reserves.

The People’s Bank of China (PBoC) is trying to jump start their slowing economy.

To put this in perspective, these are the most aggressive monetary policy measures from China since 2008. During the financial crisis, China pumped a massive 4 trillion yuan (AU$867 billion) into its economy.

As an Aussie, you remember the benefits of that.

The thing is, the rate cut isn’t the news you should be paying attention to.

This is the in your face information that most mainstream analysts will crow about over the next week or two.

However the real news for China, is hardly getting a mention.

As the investing world was digesting the rate cut, Bloomberg dropped this nugget of information:

International Monetary Fund representatives have told China that the yuan is likely to join the fund’s basket of reserve currencies soon, according to Chinese officials with knowledge of the matter, a move that may make more countries comfortable using the unit or including it in their foreign-exchange holdings.

The IMF has given Chinese officials strong signals in meetings that the yuan is likely to win inclusion in the current review of the Special Drawing Rights, the fund’s unit of account, said three people who asked not to be identified because the talks were private. Chinese officials are so confident of winning approval that they have begun preparing statements to celebrate the decision, according to two people.

If you haven’t heard of Special Drawing Rights before, let me explain.

Special Drawing Rights (SDRs), are an international form of money created by the International Monetary Fund. SDRs derive their value from a weighted average of a basket of major currencies.

With SDRs, it’s important to remember they aren’t an actual currency. Rather they’re a ‘claim’ on freely useable currencies for members of the International Monetary Fund (IMF).

The idea of SDRs is to supplement currencies reserves of a particular country. Or they can be used to provide additional liquidity if needed.

But there are two key things you need to know about SDRs.

First, they were created by the IMF in 1969, as a direct response to the limitations of gold and US dollar when paying international accounts.

And second, they are backed by nothing. No bullion, no assets and no promise of the first born.

SDRs are nothing more than a creation of powerful elites wishing to prop up the monetary system.

Including the yuan in the SDR basket, means the yuan’s become a credible, international currency.

And China, desperately wants to be invited to sit at the grown-ups table.

Even though it’s just a rumour at the moment, Bank of America Merrill Lynch estimates the yuan could have a potential weighting of 13%.

At the last IMF review in December 2010, the weighting share was divided unevenly between four major currencies: euro 37.4%, Japanese yen 9.4%, pound sterling 11.3% and US dollar 41.9%.

The potential 13% yuan weighting would likely mean both the US dollar and the pound sterling lose a significant portion of their share.

China tried to have the yuan included at the last IMF meeting. But the IMF knocked them back, explaining the yuan didn’t meet the test of being ‘freely useable’.

Freely useable can have two meanings. To some, freely useable means ‘fully convertible’. That is, a currency which is highly liquid and free from state controls. Based on that definition, the yuan isn’t freely useable.

China places tight controls on how its residents use their money. There’s caps on how much citizens can take out of the country. International companies must complete extensive paperwork before bringing any cash in. And foreigners are restricted, or limited to strict quota’s when it comes to the country’s capital markets.

These factors haven’t changed in much five years.

But there’s another meaning of freely usable. The IMF consider freely useable based on the use of a currency in international transactions. And whether it’s widely traded on global markets. So broadly speaking, the yuan now meets the criteria. Being a fully convertible currency is only an advantage to be considered for SDRs.

The thing is, the use of the yuan and state controls over the currency haven’t changed that much in five years.

Adding the yuan to the SDR basket gives the currency the credibility its leaders so desperately want.

Earlier in this year, there was some noise about China being added to the SDR basket. But the talk disappeared. And then China spent the better part of 2015 devaluing its yuan against the US dollar.

Jim Rickards — the strategist of Currency Wars Trader — said many in the markets mistook this action as retaliation for not being added to the SDR basket.

According to Jim that’s not the case.

It’s a matter of when China will be allowed in the SDR basket. He reckons the process has been ‘elongated’. Telling subscribers:

China’s devaluation was not retaliation, but a necessary adjustment to the Fed’s disastrous strong dollar policy. These policy moves are of the utmost importance to the functioning of the international monetary system.

They don’t happen out of spite. These moves may surprise markets, but they are carefully worked out behind the scenes. The elites see it coming; the everyday investor does not.

Jim says investors must be aware China will be included to the SDR basket at the IMF’s December meeting this year.

For investors, the outcome is this:

The implications for investors are profound. From now until next March, China has a free hand to weaken the yuan somewhat further. That will put more deflationary pressure on the US, make the US dollar stronger, and lead to added turmoil in US equity markets as earnings suffer due to the strong dollar.

The move to add the yuan into the SDR basket will create more market turbulence in the US. Don’t think Australia is immune from this either. These behind the scenes movements are all part of the currency wars Jim analyses on a weekly basis. To discover how to capitalise on it, go here.


Shae Russell

Editor, Strategic Intelligence

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Shae Russell started out in financial markets more than a decade ago. Working with a derivative brokering firm, she helped clients understand derivative markets, as well as teaching them the basics of technical analysis. Since joining Port Phillip Publishing eight years ago, Shae has worked across a number of publications. She holds the record for the highest-returning stock recommendation, in which a microcap stock returned over 1,200% in six months. Ask her about it, and she won’t stop yapping on. For the past two years, Shae has worked alongside Jim Rickards as his Australian analyst, translating global macro trends for Aussie investors, and how they can take advantage of these trends. Drawing on her extensive experience, Shae is the lead editor of Markets & Money. Each day, Shae looks at broad macro trends developing around the world, combining them with her distaste for central banks and irrational love of all things bullion.

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