Elephant in the room is ChinaChina has been pushing hard for the offshore component of the renminbi, the yuan, to be included in the International Monetary Fund’s Special Drawing Rights or SDR.  The SDR is essentially a basket of global reserve currencies that the IMF uses to help balance the current accounts of the global financial system.  The Chinese want desperately to have the yuan included along with the US Dollar, sterling, euro, etc.  Primarily the effect will be psychological as China will be finally seen as a global player in the world’s economy.  

China has been spending a lot of its foreign currency reserves to prop up the yuan in the last year.  Massive amounts of U.S. treasuries have been sold in the bond market to fund this effort.  The Chinese can’t do this forever and desperately need to devalue their currency in order to make their exports more competitive.  For appearance reasons, they don’t want to do this until inclusion in the SDR is assured.  The decision by the IMF could come in the early part of 2016.

Bloomberg reports on comments from Bank of America’s head of global rates, David Woo, “After the SDR they no longer have the incentive to prop up the renminbi,” he said Friday in an interview in Taipei. “A December hike by the Fed would give the Chinese a perfect excuse to let the renminbi go because they can make a strong case that they need to decouple their monetary policy from that of the U.S.”

What will happen if the International Monetary Fund delays consideration of designating the Chinese currency as a global reserve currency for another five years until the next period when the SDR basket can be changed?  It is likely that China will go ahead and massively devalue the yuan artificially.  This could cause panic in financial markets.  What consequence Will The coming Chinese devaluation Bring?

Business Insider quotes Diana Choyleva, Lombard Street Research’s chief economist and head of research,  “The Chinese leadership is not going to wait another five years for the West to deign to accept them. And they will not be so keen to be such a responsible global citizen. Because out of the major economies, the only currency that’s seriously overvalued is the yuan, and that’s the only one that hasn’t engaged in any major effective devaluation. […] If the yuan is not accepted in the SDR, they will go for a one-off large devaluation and that would then be … a financial crisis, specifically, a real-economy crisis with the resulting impact on the … markets.”

Domestically, although it would help China’s exporters, such a devaluation would have a stunning effect on China’s middle class, substantially reducing their net worth.  The average middle to upper class person in China has already experienced a serious financial setback with the equity market crash over the summer.  

Internationally, a devaluation would significantly  increase demand for other reserve currencies, artificially propping up the dollar and others.  This could have a real negative impact on global growth as the developed world’s products would instantly become so much more expensive, especially against Chinese goods.  

If the Chinese yuan is included in the SDR, China will let the yuan devalue in a more controlled manner.  Either way, China, the world’s second largest economy could precipitate more stress in the global economy.  All of these development create uncertainty in the international financial system, which all trading markets hate.