IMF move to add it as a global reserve unit will encourage central banks to hold the currency

The International Monetary Fund's review of the special drawing rights composition this year is set to open the door for the yuan to be included in the basket of major currencies.

The review takes place every five years, and opens up the potential inclusion of additional currencies. As 2015 is a review year, the IMF will vote for the decision in October.

The IMF created the SDR in 1969 as a claim on the fund members' quotas of freely usable currencies. The fund has implemented four SDR allocations to member countries, creating a cumulative 204 billion SDR equivalent to $281.5 billion (1 SDR = $1.3799 as of April 14).

SDR's value is based on a basket currently consisting of four key international currencies - the US dollar, euro, British pound and the yen.

IMF managing director Christine Lagarde recently stated that it is not a question of 'if' but rather 'when' the yuan will be included in the SDR.

"The direct implications of renminbi inclusion in the SDR would likely be minimal," Zhu Haibin, chief China economist with JPMorgan Chase & Co in Hong Kong, wrote in a recent research note. "The SDR's international financial role is minimal as it accounts for only 2.4 percent of total foreign reserves."

However, Zhu said the symbolic meaning of the yuan's inclusion in the SDR is important.

"SDR inclusion could be interpreted as international recognition of China's increased economic importance and role in global financial markets, including the establishment of the Asian Infrastructure Investment Bank and the BRICS (Brazil, Russia, India, China and South Africa) Development Bank and the promotion of regional economic integration."

The inclusion should also further encourage central banks and sovereign wealth funds to hold yuan-denominated assets, hence promoting the role of the yuan as a reserve currency, Zhu added.

The IMF has two main criteria for SDR basket membership, namely, the importance in world trade and the importance in global financial capital flows.

China has met the first criterion. Data from the World Trade Organization show that China accounted for 12.4 percent of global exports in 2014, higher than shares by the US (8.6 percent), Germany (8 percent), Japan (3.6 percent) and the UK (2.7 percent).

The main obstacle for the yuan's membership in SDR is whether it is "freely usable" in international financial transactions. In the IMF's 2010 review, the yuan was deemed to meet the first criterion but fell short on freedom of use.

The IMF sees a member's currency as freely usable if it is widely used to make payments for international transactions and is widely traded in the principal exchange markets.

The international use of the yuan has grown rapidly in recent years.

According to HSBC's survey on 72 foreign reserve management institutions across the world, the yuan will account for 12.5 percent in total global foreign reserves by 2030, surpassing the euro as the second-largest reserve currency.

For the same survey, HSBC interviewed around 1,600 enterprises globally and found that nearly a quarter of top managers hope to seize the opportunities brought by the yuan's internationalization.

"In the past, overseas companies used renminbi only in the trade with China. Now more managers have begun to reevaluate renminbi as an important currency in world trade," says Zhao Minzhong, vice-president of HSBC Bank (China).

"It means that renminbi is well on its path to become a truly internationalized currency."

A report on SDR by the Singapore-based United Overseas Bank says that the likelihood of the yuan to be included in the SDR this year is 60 percent.

In the report, 35 among the 72 surveyed central banks said that they either have or are considering investment in yuan-denominated assets. But their major concern is the limited access to the Chinese domestic market.

These central banks mainly invest offshore interbank bond markets and dim sum bonds for yuan assets. However, they are more interested in bonds issued by the Chinese government or high-return bonds issued by Chinese policy banks.

Quan Dejian, senior economist with the UOB, says that the Chinese currency should become a candidate for a reserve currency as its profile in the international economy rises.

China is gradually opening up its capital account to the global market. If the yuan can join the SDR, more countries will choose it as their reserve currency.

Moreover, the yuan can be more competitive in pricing bulk commodities because China is such a large consumer, says Quan.