CHINA JOINS WORLD'S ELITE CURRENCY CLUB

By Ian Talley

China notched an economic milestone Monday, with the International Monetary Fund adding the yuan to its elite basket of reserve currencies, a move designed to spur greater liberalization in the world's No. 2 economy.

The decision -- effective next October -- confers international status on China's currency as the government starts to ease restrictions on its rigidly controlled exchange-rate and financial system. It also marks the start of a potentially more perilous course for China. A more freely traded yuan and open markets, down the road, could add volatility to China's trade picture and raise the risk of capital flight.

The IMF's decision will eventually put the yuan alongside the dollar, euro, pound and yen in the fund's reserve-currency basket, with the IMF giving more weight to China's currency than to either the yen or pound.

But while the decision is a boost for China's national self-esteem, itisn't likely to drive a huge surge in yuan buying. Nor is there much threat the yuan will soon displace the dollar as the world's pre-eminent reserve currency, especially given China's many political and economic challenges.

"This inclusion is clearly an important milestone in a journey . . . that will include certainly more reforms," IMF Managing DirectorChristine Lagardesaid after the board approved the yuan's inclusion.

Anointing the yuan as a reserve currency is in part a simple acknowledgment of China's economic heft: The country now accounts for more than 15% of the global gross economic output, nearly triple what it was a decade ago.

And for the Chinese, the yuan's higher status is part of a larger strategy to boost the country's economic leverage. The government has ramped up lending to foreign governments, greatly expanded trade settled in yuan and created emergency credit facilities for other governments. Earlier this year, it launched the Asian Infrastructure Investment Bank, an institution analysts say was designed in part to rival the Washington-based World Bank.

Still, inclusion of the yuan in the IMF basket is in large part symbolic. The IMF uses the reserve basket to denominate its emergency loans, not to create an internationally traded asset.

Whether the yuan is embraced by central banks as a reserve currency will hinge on Beijing's success in deepening its financial system and adding far greater transparency to the inner workings of its economy.

Over the past year, Beijing has rolled out a series of policies -- including freer interest rates and easier foreign investor access -- to meet the IMF's criteria for yuan inclusion in the IMF's Special Drawing Right lending basket.

IMF staff say the yuan easily met the first measure: The currency must be issued by a major exporter. But IMF economists in August questioned whether the currency met the second benchmark of being "freely tradable."

Beijing authorities subsequently rolled out several more financial-sector overhauls, including a devaluation that the authorities said was intended to make the yuan's value more market based.

U.S. officials privately question the yuan's ripeness for reserve-currency status but also see the step as aiding efforts by reformers within the People's Bank of China to liberalize the country's economy. The U.S. Treasury issued a short two-line statement saying it supported the IMF staff recommendation to include the yuan.

After the IMF's announcement, China's central bank pledged to accelerate efforts to overhaul the country's financial system, further open its markets and keep the yuan largely stable.

Inclusion of the yuan "means the international community expects China to play a more active role in global economy and finance," the People's Bank of China said. "China will speed up the effort to promote financial reforms and opening."

Eswar Prasad, a Cornell University economist and former top China hand at the IMF, said the IMF's decision will strengthen the hands of economic reformers but warned of obstacles ahead.

"Domestic opposition to further financial-sector reforms and market-oriented liberalization measures remains fierce, and this decision by itself is unlikely to shift the balance substantially," he said.

The more China opens up its markets, the more it exposes its economy to the risk of capital flowing out. If China were to open up its markets more broadly, cooling growth prospects could turn such investor exodus into a stampede of cash out of the country, as many emerging markets have experienced in recent months.

Some fund watchers also say that support in the international community for the move is partly political consolation for the failure of the IMF to overhaul the lending institution's governance structure to give China and other emerging-market nations more of a vote in line with their evolving economic heft in the world.

The decision by U.S. lawmakers to repeatedly reject ratification of a governance deal is a sore point for China and other developing powers. They say that snub by the shareholder-run IMF is prompting them to create their own international economic institutions. Awarding Beijing's currency reserve status is designed in part to encourage China's government to greater international political and economic responsibility.

Several U.S. lawmakers who have long castigated China for its currency policy criticized the IMF's decision.

"This decision does nothing but validate China's history of cheating on its currency," said Sen. Bob Casey (D., Pa.). Sen. Charles Schumer, (D., N.Y.), said "the IMF is choosing to reward China's currency manipulation instead of combating it."

Failure to win IMF reserve-currency status would have also been an embarrassment for China's leadership as it takes over the rotating presidency of the Group of 20 major economies next year.