The rise of the renminbi: how adding China's yuan to IMF's SDR basket will spur the currency towards further reform

The yuan's rising global importance - as seen in the International Monetary Fund's expected decision last night to add the renminbi to its basket of lending reserves - marks a milestone in China's push to internationalise its currency.

The move for the yuan to join the Special Drawing Rights basket, if approved, would make China the first developing country to join the group, which comprises the US dollar, euro, pound sterling and Japanese yen.

It would also serve to dispel critics' doubts of China's will to implement the financial reforms it needs to support long-term economic growth.

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While any direct impact may not be immediately visible, the IMF decision will push the government to continue helping its yuan capital market mature - with more diversified products and active market transactions both onshore and off.

"Efforts for the yuan to be included in the SDR have become an irreversible push towards financial liberalisation, which will have a profound impact on China's economy," leading brokerage China International Capital Corporation (CICC) said, comparing the move with China's entry into the World Trade Organisation in 2001, which resulted in further reforms to better integrate with the world economy.

Huang Yiping, Peking University economist and central bank monetary policy adviser, said: "The [reform] direction is very clear, [that is, towards] a more flexible yuan and market-driven interest rates, further opening up of the capital account and greater global use of the yuan."

The IMF in August said it expected the changes to how China was managing its currency to bring the yuan exchange rate "quite close to a float" in two to three years. This came after the central bank, the People's Bank of China, made its yuan-fixing system more market-driven.

Monetary authorities are also expected to soon start a programme allowing individuals to make direct outbound securities investments; raise the quota for two-way securities investments under pre-existing arrangements, and launch a stock connect scheme between the Shenzhen and Hong Kong bourses.

Foreign exchange traders are anticipating an extension of onshore trading hours to overlap with those of the offshore market, while brokers expect the PBOC in future to intervene in the forex market only in extreme cases.

Analysts say China has to improve its currency's market depth by developing its capital markets, especially the yuan-denominated bond market and stock market to draw foreign investors to hold the currency.

"Developing the capital market - especially the bond market - is crucial for post-SDR yuan internationalisation," Citic Securities said.

Citic said it saw huge potential in the bond market, with China's lack of short-term bond products - products with terms shorter than a year account for only 14 per cent of all bonds - and its sovereign bonds' low turnover compared with its neighbours such as India and Thailand.

The Finance Ministry in October started regularly issuing three-month treasury bonds to provide the IMF with pricing references for SDR interest rates. The bond issuance will also help improve the country's sovereign bonds yield curve to better reflect market demand and supply and give it a bigger role in the distribution of financial resources - a goal set in 2013 by central bank governor Zhou Xiaochuan .

The top leadership has vowed to revamp the financial regulatory regime after this summer's stock market rout. With the resumption of initial public offerings this month after they were suspended in July, there are expectations that Beijing will reinstate to its agenda revisions to the securities law, which include reforming the IPO registration system.

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"Although the yuan internationalisation is expected to progress regardless of the IMF's decision, admission of the currency to the SDR basket would help build confidence in the long-term nature of the trend of wider international yuan usage, encourage more central banks to hold the yuan as part of their foreign exchange reserves and, by extension, the availability and demand for yuan-denominated assets," said Mark Boleat, policy chairman of City of London Corporation.

Still, even if the yuan is indeed added to the SDR, it remains far from replacing the US dollar as the top world currency. The US dollar accounts for 64 per cent of global reserve currencies and nearly 90 per cent of foreign exchange transactions.

"There's no doubt the yuan will be widely used in the world, but it still has a long way to go," Citic Securities said.