The IMF has approved China’s renminbi as one of the main world currencies. (Reuters)

Monday afternoon, the International Monetary Fund’s (IMF) Executive Board voted in favor of allowing China’s currency — the yuan (or renminbi) — to join the ranks of the world’s most elite monies. On Oct. 1, 2016, the yuan will officially be added to the IMF’s Special Drawing Rights (SDR) basket of currencies, which previously included only the dollar, euro, yen, and pound sterling.  The decision to include the yuan in the basket indicates the board felt the yuan meets the required “freely useable” standard, meaning it is widely used to settle international transactions and widely traded in foreign exchange markets.

The move legitimizes the yuan as a global reserve currency — an important designation that I will explain below. And which governments will start investing most significantly in yuan? Those that dislike the U.S.-led international order, as I will explain.

What is a reserve currency?

Just like individuals, governments maintain their own investment portfolios that function as a sort-of “rainy day fund.” Typically, central banks operate as their country’s investment managers, regularly making decisions about how best to allocate the government’s financial assets.

A key part of this process is deciding on the currency denomination of their investments. For example, if a central bank decides to invest heavily in Treasury bonds, that means the country holds a lot of U.S. dollars in reserve. Investments in German government bonds, conversely, represent euro holdings. These assets are appropriately referred to as “foreign exchange reserves.”

Central banks typically hold a blend of currencies in their foreign exchange reserves. Today, the U.S. dollar is the world’s most popular reserve currency, representing roughly 64 percent of global reserve assets. The second most popular is the euro, at about 20 percent, and the pound sterling and yen come in at about 5 and 4 percent respectively.

That means roughly 93 percent of the world’s foreign exchange reserves are held in one of these four currencies. Typically, when people use the term “reserve currency” they are referring to this exclusive group.

These are the four currencies listed in the IMF’s SDR basket. In practical terms, the SD­R’s primary function is as a unit of account for the IMF, with official IMF documents reporting the institution’s own assets and liabilities in SDR terms. Its value, which changes daily, is based on the exchange rates of the four — soon to be five — currencies in the SDR basket.

Why does the IMF’s decision matter?

The IMF’s opinion means something to reserve currency managers and financial markets. Including the yuan in the SDR basket can be thought of as the IMF’s Good Housekeeping “Seal of Approval,” signalling that it is ready for the big time as a global investment and trade settlement currency.

Recently, one major global bank predicted that SDR classification could lead asset managers, including central banks and private investors alike, to shift a whopping $1 trillion into yuan. Issuing a top reserve currency tends to be quite beneficial. For example, the dollar’s role as a top reserve currency is one of the reasons the U.S. government is able to borrow from foreign creditors so cheaply. These low rates are transferred on to American citizens. Estimates suggest that top reserve status confers an estimated $100 billion on the U.S. economy, annually.

If global demand for the yuan grows, Beijing would benefit in similar ways.

Of course, SDR classification alone will not propel the yuan to challenge the dollar for the position of top global reserve currency. Reserve decisions are largely driven by the economic attractiveness of particular currencies.

Governments that issue top reserve currencies need to provide large and open financial markets where foreign investors — including central banks — can buy and sell assets in the currency freely and quickly. China is slowly moving in this direction.

A relatively stable exchange rate also enhances a reserve currency’s economic attractiveness. Similarly, the more the yuan is used in trade settlement and debt markets, the more likely central banks are to increase their holdings of the currency.

But economics are not everything. Governments also select their reserve currencies in part as votes about which global political order they prefer, as Steven Liao and I argue in a forthcoming article at International Studies Quarterly.

The geopolitics of choosing a reserve currency choice

Increasingly, scholars and observers are arguing that the ideas and principles that underlie the existing, U.S.-led liberal order are being contested. China is the key challenger to the status quo order based on U.S. military preponderance, democratization, human rights, and the globalization of free market capitalism

Liao and I explore whether a state’s decision to hold yuan should be influenced by what international order it prefers. The dollar’s position as top reserve currency is a potent symbol of American power. Consequently, national decisions to invest in yuan may be symbolic repudiations of American dominance, and endorsements of an alternative world order with Chinese characteristics.

We argue that countries that support the U.S.-led order should be less inclined to diversify their reserves into yuan. Conversely, states that are less supportive of the U.S. order should be more likely to shift reserve assets into yuan.

In our paper, Liao and I identify 37 central banks that added yuan to their foreign exchange reserves between 2010 and 2014 (prior to the IMF’s SDR classification). We then estimate a statistical model of reserve currency choice.

Using a new measure of satisfaction with the U.S. order by Michael Bailey, Anton Strezhnev and Erik Voeten, we find that the single best predictor of an official investment in yuan is a country’s (dis)satisfaction with the U.S.-led order. In fact, this measure clearly outperforms a battery of measures designed to account for variation in the economic attractiveness of the currency.

Our findings suggest that the trajectories of new reserve currencies are influenced by geopolitical forces. At least in this early stage, China’s position as America’s geopolitical rival seems to have increased interest in the yuan as a reserve currency among countries that are dissatisfied with the U.S. order.

Ultimately, the economic attractiveness of the yuan will have the greatest impact on the currency’s position in the global reserve system. China must also further open its domestic financial markets to foreigners and remove its grip on the yuan’s exchange rate if it is to truly challenge the dollar.

If Beijing can accomplish these things, the yuan’s share of global reserves should grow. Our results imply that the yuan will be most popular among countries that share a distaste for U.S. primacy. Thus what may emerge over time is an increasingly politicized global reserve currency system where geopolitical preferences influence the “blend” of currencies central banks hold in their coffers.

Daniel McDowell is an assistant professor of political science at The Maxwell School of Syracuse University.