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Inclusion Of Renminbi Into The IMF's SDR Basket: The Beginning Of China's Financial Reform
December 11, 2015

We believe that the inclusion of Renminbi into the IMF's Special Drawing Right (SDR) has limited impact on the market in the near term, although it is positive for China in the long run.


Author : iFAST Research



 Inclusion Of Renminbi Into The IMF's SDR Basket: The Beginning Of China's Financial Reform

KEY POINTS:

1. On 30 November 2015, the IMF has decided to include Renminbi into its SDR basket, with an allocation of approximately 10.92%. The inclusion of Renminbi into the SDR basket can be viewed as an important milestone that will set the stage for the acceleration of financial reform in China.

2. The stabilization of currency exchange rate remains the top priority for the People’s Bank of China (PBoC) at this juncture. As such, we believe that the Renminbi inclusion might be of limited impact to the market in the near term. Nevertheless, as the Renminbi gradually liberalises, it might become a free-floating currency over the long term. Renminbi is the only emerging currencies within the SDR basket, and should serve as the only option to mitigate emerging market currency risk.

3. Over the long term, the inclusion of Renminbi into the SDR basket might increase investors’ demand for Renminbi-denominated asset. The further liberalization of Renminbi, along with the increase in the variety of Renminbi-denominated financial assets, should help to increase foreign capital inflow into these assets. The Renminbi should also serves as an extra risk management tool aside from the US Dollar, euro and yen.

4. While China currently has the world’s third largest bond market, foreign investment in the bond market merely stood at 1.8%. The inclusion of Renminbi into the SDR market indicates the prominent role of Renminbi in the FX market. Foreign investors, who hold Renminbi, will diligently seek out for fixed income products and this should encourage the development of onshore and offshore local currency bond market. China’s government will also encourage more introductions of Renminbi-denominated financial products, which is likely to broaden the range of these assets offered in the market.

5. Although Renminbi has been included in the SDR basket, this does not influence market expectation of a depreciation path for the Renminbi. The main factor driving the movement of the Renminbi remains to be People’s Bank of China’s (PBoC) benchmark interest rate. As compared to the real interest rate in the developed markets, PBoC still have ample of room to cut rates. We expect the Renminbi to depreciate gradually moving forward under the government’s prudent policy guidance, reaching a currency exchange rate of 6.6 Renminbi to 1 US Dollar within one-year timeframe.

FOREWORD

On 30 November 2015, the International Monetary Fund (IMF) has decided to include Renminbi into the Special Drawing Right (SDR) Basket, with an allocation of 10.92%. SDR is an international reserve asset that allows member countries to utilize it for trade payments, debt and interest repayments and also serve as the unit of account of the IMF. The inclusion of Renminbi into the SDR basket can be viewed as an important step that will accelerate the financial reform in China. Although the weight of Renminbi in the SDR basket is lower than consensus’ expectations of 14% to 16%, its weight has surpassed the allocation of yen (down from 9.4% to 8.3%) and pound (down from 11.3% to 8.1%) within the basket, making it the third biggest currency in the basket.

MORE VARIETY OF RENMINBI-DENOMINATED FINANCIAL PRODUCTS, INCREASED DEMAND FOR THE RENMINBI LIBERALISATION FROM INVESTORS GOING FORWARD

At this juncture, the stabilization of the Renminbi remains to be the main objective for the People’s Bank of China (PBoC). As such, we believe that the impact of the Renminbi inclusion on the currency exchange rate is likely to be minimal in the near term. While there is no direct relation between the inclusion of Renminbi into the SDR basket and the timing for China to push out their plans for financial reforms, it is likely that the range of Renminbi-denominated financial products in the foreign market will broaden going forward. By then, the demand for Renminbi to fully liberalised and freely flow in the market will increase. Over the long term, Chinese government might consider converting Renminbi into a free-floating currency.

RENMINBI, THE ONLY EMERGING MARKET CURRENCY IN THE SDR BASKET

Currently, Renminbi is the only emerging market currency in the SDR market. This means that Renminbi is the only option for SDR users (such as central banks) to manage emerging market currency risk. Over the long term, investors might have increased demand for Renminbi-denominated assets. Further liberalization of the Renminbi, along with the broadening range of Renminbi-denominated investment assets, should see increase foreign capital inflows into these assets and Renminbi will serve as a risk management tool, aside from major currencies such as the US Dollar, euro and yen.

FURTHER OPENING UP OF CHINA’S ONSHORE BOND MARKET

Currently, China has the world’s third largest bond market, with the significant players in the market being the domestic commercial banks, constituting approximate 62.47% of the total market cap. Foreign participation within the domestic bond market, on the other hand, only stood at merely 2.2%. With the inclusion of Renminbi into the SDR basket, it is likely for Renminbi to play a significant role in the FX market. Foreign investors that hold Renminbi will definitely seek for fixed income investment and this might encourage the development of onshore and offshore Renminbi-denominated bond market. China’s government will also encourage more introductions of Renminbi-denominated financial products, which is likely to broaden the range of these assets offered in the market.

Figure 1: Onshore bond market: Investors’ composition

 

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MARKET EXPECTATIONS OF THE REMINBI DEPRECIATION REMAINS ALBEIT SDR INCLUSION, CURRENCY MOVEMENT DEPENDS ON PBOC MONETARY POLICY ACTION

Although the Renminbi has been included into the SDR basket, this does not affect market expectation of a depreciation path for the respective currency. We believe that the movement of the gradually liberalizing Renminbi will still depends largely on PBoC’s monetary policy direction. As compare to the real interest rate in the developed markets, there is still ample room for PBoC to cut interest rate. We remain our expectation that the Renminbi will depreciate gradually moving forward under the government’s prudent policy guidance, reaching an exchange rate of 6.6 Renminbi to 1 US Dollar within one-year timeframe.

Figure 2: China vs. Developed Markets: Real interest rate movement

 

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As depicted in the article “Will Renminbi continue to devaluate?”, we believe that the depreciation of the Renminbi is positive for China’s economic growth over the long term and is likely to contribute to a more efficient redistribution of resources. Under the new currency exchange rate mechanism, market supply and demand should lead the Renminbi to a more normalized level and the expectation for the depreciation of the Renminbi should persist going forward.


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