Renminbi – opening the gates
Expect significant inflows into renminbi following the news that it has been included in the SDR basket of major currencies
Following the earlier announcement in November that the renminbi (RMB) meets the International Monetary Fund’s (IMF’s) criteria as a ‘freely usable’ currency, the IMF Executive Board has now formally decided to include the RMB in its Special Drawing Rights (SDR) basket of currencies from 1 October next year.
This came as no surprise to those who have followed China’s unprecedented steps to open up its capital markets.
A monumental milestone for the RMB – which enters the SDR with a weighting of almost 11 per cent – this event will trigger significant but gradual inflows of funds into RMB, changing the global currency landscape forever, as central banks, sovereign wealth funds (SWFs) and multilateral institutions recalibrate their balance sheets.
“As many as 70 central banks have already invested part of their reserves in renminbi”
Many will not wait until next year before taking action. Indeed, as many as 70 central banks have already invested part of their reserves in renminbi, either onshore or offshore.
The reforms made by China to qualify for SDR inclusion have been so radical that – to public sector investors – the RMB has become fully convertible with no restrictions on access or size of investment in the China interbank bond market, something which has largely gone unnoticed.
Five out of the world’s 10 largest central banks have so far refrained from investing in the Chinese interbank bond market. However, because of China’s recent reforms, these and many other public sector investors are now reviewing their stance.
Double-digit share of global reserves
Eventually, we should expect to see RMB reach a double-digit share of global reserves – inflows in the order of USD800 billion to more than USD1 trillion. Even a conservative estimate of reallocation of about 1 per cent of global reserves each year would mean about USD80 billion inflows annually – no mean sum
Added to the moves by central banks will be those by SWFs. Though SWFs typically have smaller fixed income allocations, their investments will be sizable, too. Norway’s SWF alone is likely to invest over USD40 billion.
The implementation of the RMB’s inclusion in the SDR basket 10 months from now will also inevitably trigger a significant rebalancing or hedging demand for the Chinese currency, though this, too, is likely to occur gradually.
By far the most significant effect from the RMB’s inclusion on currency flows will come from multilateral institutions
Contrary to common perceptions – given that the aggregate SDR assets of the central banks in the IMF member states (around USD280 billion) have an equal amount of SDR liabilities – the RMB’s addition to the SDR basket will not actually trigger a system-wide hedging demand, though some countries that are long or short on SDR may hedge their positions.
Instead, by far the most significant effect from the RMB’s inclusion on currency flows will come from multilateral institutions. The IMF’s own investment account and investment by its Poverty Reduction and Growth Trust would need to be rebalanced to include the RMB.
Likewise, institutions such as the Bank of International Settlements, the African Development Bank, the Islamic Development Bank, the Arab Monetary Fund and the International Fund for Agricultural Development have SDR-denominated balance sheets, which will need to be rebalanced.
The World Bank and Asian Development Bank would also be affected as some of their facilities for the world’s poorest countries are denominated in SDR. The combined size of these multilateral institutions’ SDR-denominated balance sheets is around USD600 billion, so the resulting RMB flows could be over USD65 billion.
Private sector investors are yet to enjoy the same unfettered access to RMB investment as their public sector counterparts, but the sheer speed and extent of China’s reforms in the past year strongly signals China’s intent to accelerate the full opening of its capital account. This may happen a lot faster now than people currently expect.
The ‘ifs’ and ‘buts’ for the RMB are over. For those who are yet to formulate an RMB strategy, now is the time.
This article was first published in The Financial Times on 30 November 2015