On November 30, 2015, the International Monetary Fund (IMF) announced its decision to add the Chinese renminbi (RMB) to the basket of currencies that make up the Special Drawing Right (SDR). The IMF SDR basket inclusion criteria—last updated in 2000—requires that the SDR basket comprise currencies whose exports of goods and services had the largest value over a five-year period, and have been determined by the IMF to be “freely usable.” The Chinese RMB has long met the first criteria of a currency whose exports of goods and services play a central role in global trade. However, during the last review in 2010, the RMB was denied entry into the SDR basket because the IMF determined that it did not meet the “freely usable” criteria.
The IMF defines a “freely usable” currency as one that is “widely used” to make payments for international transactions and is “widely traded” in the principal exchange markets. It is worth noting here that, contrary to popular belief, a country DOES NOT need to have an open capital account to have its currency be included in the SDR.
The IMF further notes that definition of a freely usable currency “requires interpretation,” and the determination of which currencies are freely usable “requires judgment.” In short, it is as much of a qualitative/political call as it is a quantitative criterion.
We expect the short-term market price impact on RMB would be gradual and small due to the IMF delaying any actual changes to its SDR basket to October 1, 2016, when the renminbi will be added as a fifth currency, along with the U.S. dollar, the euro, the Japanese yen and the British pound. However, beyond the price impact, we believe the more important aspect of the result is the signal it sends. It is a vote of confidence by the IMF on the currency. Within China, it is also a catalyst for further financial sector reforms such as capital account opening and relaxation of foreign exchange regulations.
In the long run, we believe the central bank’s demand and general demand for RMB will increase for two reasons:
- Increase of RMB demand as central banks try to match the RMB’s weights in the SDR
- Increase of general RMB demand as further reforms on China’s capital account and foreign exchange make RMB a more market driven currency
For long-term investors, it is important to note that the RMB is increasingly becoming internationalized and gaining recognition as a major world currency. Reforms, driven by the SDR inclusion to liberalize foreign exchange markets and capital accounts, will make the RMB more “freely usable” for investors. This event is also important for the Chinese government as the country further endeavors to develop its domestic bond market. Central banks (and institutions to a certain extent) invest the vast majority of their assets in bonds and other fixed income products. The expected long-term inflow from foreign central banks into the Chinese fixed income market will also be a catalyst for further development of the China fixed income market.
We think these same reforms to the capital accounts will eventually pave the way for a vibrant domestic bond and equities market and their eventual inclusion in the world indices. When China’s securities are included in the world indices, this will be transformational for investors worldwide.
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