China’s Yuan — In The Big League!
Published on 15 Dec, 2015
In the past decade, China has taken unprecedented steps to open its capital markets and internationalize its currency. The recent announcement of the renminbi (RMB)’s inclusion into the IMF’s reserve currency basket is seen as a vote of confidence in the country’s efforts to liberalize its financial markets. It also reinforces China’s growing importance in the global economy - the Yuan is the only emerging market currency in the IMF’s elite reserve currency list, commanding a higher weight than the yen or pound.
Yuan Rising Through the Ranks
The Yuan’s inclusion does not come as a surprise, considering its current global rankings: fifth among the world’s most used currencies and the most-used currency for intra-regional payments in Asia-Pacific. This is indeed a notable achievement as the RMB, at the 14th position just three years back, has now overtaken six other currencies. Despite this, the Yuan remains a small player at the global level in terms of volumes, accounting for 2.45% share of transactions worldwide. We believe its inclusion in the SDR basket would help the currency gain further traction in the international market and (consequently) boost transaction volumes.
Impetus for Further Reforms
While China has made significant progress in its efforts to internationalize its currency, there is significant room to achieve full convertibility and move towards a market determined exchange rate. Status as a reserve currency alone does not guarantee the currency’s economic attractiveness, as investors still have limited access to China’s financial markets. The IMF’s endorsement of the efforts of Chinese policy makers is expected to act as a catalyst and drive further reforms towards making the currency ‘freely usable’ and liberalize the country’s capital account.
Substantial Inflows in the Long Term
The reweighting of the IMF’s SDR assets is not expected to have a significant impact on the demand for the Yuan in the short term (estimated to be approximately US$30 billion, a modest amount given the size of the Chinese economy). However, the impact is likely to be more pronounced in the long term as central banks, sovereign wealth funds and other major multilateral institutions reallocate their balance sheets to reflect the redistribution in SDR weights. It is estimated that as many as 70 central banks already have allocated some part of their reserves in RMB assets. Over the next decade the impact of the rebalancing could see reserves to the tune of up to US$1 trillion flowing into Chinese assets, significantly altering the global currency landscape.
Positive Impact on Chinese Corporations
The rapid internationalization of the Yuan and its growing use in cross-border trade settlements is expected to benefit Chinese corporations. Chinese firms, especially SMEs, will be able to use the RMB as an invoicing and settlement currency in cross-border trade, which would lower exchange rate-related risks and reduce transaction costs (the cost of transacting in US dollar is 2–3% higher than that of transacting in the local currency, according to PBOC). In addition, larger Chinese companies would be able to raise funds from international markets in the operating currency, instead of US dollar, thereby reducing their currency exposure.
Neutral Impact on the Stock Market
In our view, the reweighting may not have a direct impact on foreign investor appetite for domestic equities, especially after the pessimism triggered by the market meltdown and the nature of subsequent government intervention. However, the conferring of the SDR status on the RMB, perceived as IMF’s endorsement of China’s financial reform agenda, is likely to lift investor sentiment. In the medium to long term, the potential inclusion of Chinese A-share stocks in MSCI’s Emerging Markets index is expected to have far greater impact on inflows in the domestic stock markets.