FX: RMB joins the SDR basket
The renminbi’s inclusion in special drawing rights (SDR) is 'the biggest structural event in FX since the creation of the euro'.
The RMB became the first emerging market (EM) currency to be included in the IMF’s SDR basket on Saturday.
The move had been well flagged, and was seen by many to be a technical issue of principally symbolic significance, with the market barely registering the event. However, while little has changed in the short term, the longer-term implications are significant.
The RMB becomes the fifth currency in the basket for SDR – the currency in which the IMF makes loans, joining USD, EUR, GBP and JPY. It starts with a weighting of 11%, with the IMF reviewing the weightings every five years, and if China makes more progress liberalizing its capital account, in time it might see its weighting increase.
The market’s response was muted.
Alicia García Herrero, chief economist for Asia Pacific at Natixis and senior research fellow at Bruegel, a think tank, says: “We saw RMB appreciate on October 1, but we believe that was due to state intervention to celebrate the event – given how thin liquidity was, it didn’t take much to move the market.”
However, David Clark, chairman of the Wholesale Markets Brokers’ Association (WMBA), believes the event will come to be seen as far more significant than many have given it credit for.
“The composition of reserve assets tends to reflect relatively closely their weightings in the SDR basket,” he says. “It won’t happen overnight, but over time RMB allocations can be expected to rise markedly, from around 1% now, to around 11%, likely at the expense of sterling, yen and euros.”
This might not mean huge purchases of RMB assets in the market. More likely, institutions will hold on to their RMB earnings, he adds.
“The inclusion of the RMB in the SDR is a significant structural event, which is rare in currency markets, and quite unlike other big events such as Brexit, the SNB crisis or political developments that move markets,” says Clark.
“You could argue it is the biggest structural event since the creation of the euro, the reunification of the East and West mark in 1990, and even the collapse of the Bretton Woods fixed exchange-rate system in the 1970s. This is less spectacular, but has similar long-term consequences. It is the advent of a new era.”
Of particular significance is the IMF’s tacit acknowledgement that the old order, in which the global economy was dominated by a small number of developed economies, is no longer relevant.
Tiecheng Yang, partner at Clifford Chance in Beijing, says: “It is significant that the RMB has become the first developing economy currency to be included in the SDR basket, which makes the SDR more diversified.”
The development can, therefore, be seen as a win for EMs everywhere, and could be the first step in a more comprehensive reorganization of the SDR.
Herrero at Natixis says: “I would not be surprised to see the RMB weighting increased in 10 years, and it could also be joined by other EM currencies. The Indian rupee is very liquid and could be a candidate, as could the Brazilian real. The Russian rouble is also a possibility, though this is less likely because its bond market is much smaller.”
For now, RMB’s new role is a clear acknowledgement of China’s unique status, and its remarkable growth in recent years.
According to the Bank for International Settlements’ 2016 FX survey, the Chinese renminbi is the most actively traded EM currency, having overtaken the Mexican peso, and is ranked eighth overall.
Dan Marcus, CEO of ParFX, says: “This is an enormous achievement for a currency that wasn’t easily accessible to mainstream investors a decade ago.”
Dan Marcus, ParFX
For Marcus, it is RMB’s growth, rather than the technical change to the SDR composition, that represents the real seismic shift.
“The renminbi’s role in foreign-exchange trading and cross-border payments has surged to such an extent that its growth is now considered by many to be the most significant development in currency markets since the introduction of the euro in 1999,” he says.
What is clear is there will be no sudden change in demand for RMB.
“It will be difficult for central banks to justify increasing their allocations to RMB in the short term because the general expectation is that the currency will be depreciating going forward,” says Herrero. “In the long term, of course, they will, but before they hold more RMB bonds they will want to see greater liquidity in the market.”
Yet central banks have already been increasing their RMB assets for some time – albeit gradually. Singapore, for example, made RMB its formal foreign reserve currency in June.
This is because SDR inclusion removes technical hurdles for reserve investments in RMB assets. Taking on the status of ‘a freely usable currency’, countries can now report their RMB asset holdings as part of their official FX reserves, rather than, in the case of the Monetary Authority of Singapore, as ‘foreign currency assets’.
“It means countries that strictly follow IMF guidelines would artificially under report their official FX reserves if they diversify investments into RMB in the past,” says Becky Liu, head of China macro strategy at Standard Chartered. This technical issue has been resolved with RMB’s newly acquired status.
China will not want to push for increased use of RMB. They will be watching to see what the impact of this move will be, because it is unpredictable and they like to have as much control as possible - David Clark, WMBA
Investors will remain cautious as they consider various factors, such as credit risk and price, but over time demand for RMB assets will only increase among central banks, sovereign wealth funds and others.
“That means we will need more RMB-denominated supply,” says Clifford Chance’s Yang.
China might decide to commence a government debt programme, to provide high-quality RMB assets for investors looking to increase their allocations. RMB-denominated issues from other sovereigns, such as the UK, are also likely, now it has SDR status, which will increase supply. Major international corporations will also be considering RMB issuance.
However, the development of the RMB bond market is just one item on China’s to-do list of market reforms, which will be necessary to encourage even greater use of RMB. Few are willing to predict when any of these changes will occur.
David Clark, WMBA
WMBA’s Clark says: “China will not want to push for increased use of RMB. They will be watching to see what the impact of this move will be, because it is unpredictable and they like to have as much control as possible.”
Rachael Hoey, head of Asia at CLS, says to attract investment, eventually China “must develop deep and liquid domestic financial markets, which includes availability of hedging instruments, to give confidence and broaden its appeal to a wider group of market participants”.
She adds: “Investors are generally reluctant to make any significant investments in a market if it is too illiquid or does not allow them to enter and exit positions easily.”
Further market liberalization is difficult for China, given pressure on outflows is still high. Allowing capital to move freely could, therefore, prove highly destabilizing for China – and by extension the rest of the world.
However, there are things it can do in the short term.
“It must also establish a transparent and consistent legal regime, in line with international standards, to provide investors with the confidence that they will be treated fairly if disputes arise,” says Hoey.
“China must evaluate and consider the usage of market infrastructures that provide the risk mitigation and efficiencies necessary to effectively manage and hedge risks with respect to cross-border investments.”