Aidan Yao, senior Emerging Market economist at AXA Investment Managers (AXA IM), discusses the details and implications of the IMF’s recent policy paper and concludes that while the RMB’s inclusion in the SDR has been postponed, the outlook for the currency to be included this year remains positive.
- We think the renminbi (RMB) still stands a good chance to be included in the Special Drawing Rights (SDR) this year – a view not swayed by the recent International Monetary Fund’s (IMF) Report.
- We believe the IMF has proposed to postpone the implementation of the new SDR basket to Sept-2016, NOT the Review decision itself.
- The IMF has recognized the progress made by the Chinese authorities to make the RMB more “freely usable” – an important criterion for the SDR inclusion.
- At the same time, the Report highlights a number of operational hurdles that still need to be overcome.
- The proposed delay on the implementation of the new basket is driven by operational considerations, and the move does not prejudge the Review outcome.
- We do not think the Report will affect the path of the RMB exchange rate (the fixing rate), which will likely remain stable in the coming months.
- But there is a possibility of a band-widening in the near future, which could cause the spot rates to depreciate slightly.
The IMF issued a policy paper (The Report) this week, providing a review on the valuation method for the SDR. This precedes the quinquennial Review of the SDR composition, which in our view could still happen later this year and after the Fund’s technical assessment of the RMB for the SDR inclusion over the last two months.
The Report takes a significant effort to explain the SDR criteria and discusses where the RMB stands on the technical, operational and implementation aspects. We summarize the key takeaways below and provide our interpretations:
- The Review decision will still be made this year. Many have interpreted the recommendation in the Report to “extend the current SDR basket until September 2016” as a delay to the Review decision. We think this is a misinterpretation. By going through the document carefully, we think the proposed delay is referring to the actual implementation of the new SDR basket – the current one will expire on 31-Dec-2015 – not the decision on the SDR composition, which in our view could still take place in Q4 this year. The Report clearly stated that “this proposal (on the implementation of the new SDR basket)…does not prejudge the timing and outcome of the Review”. It is indeed possible that, should the Fund accept the proposed delay on the implementation, it may also postpone the Review decision, but there’s nothing in the Report that would indicate such a change is forthcoming.
- The RMB has made significant progress for being “freely usable”. As discussed in our recent publication, there are two broad criteria for a currency to be SDR eligible: 1) significant usage in global trade and 2) it being “freely usable”. The RMB’s status as a trade currency has risen significantly on the back of China’s increasing dominance in global trade and the official push to make the RMB an internationalized currency. However, given the long-standing capital controls, the RMB’s participation in global financial flows has been limited until recently. Nevertheless, the IMF has recognized the substantial progress made by the Chinese authorities to increase the RMB presence in global financial/portfolio-related flows, by stating that “across a range of indicators (see table below), the RMB is now exhibiting a significant degree of international usage.” We think this endorsement on the technical aspect of the RMB usage will be important for the Review decision later this year.
- But the RMB inclusion still faces a number of operational hurdles. The Paper laid out a few operational issues that still need to be addressed to facilitate the investment of the IMF and other SDR users in the RMB, if it was to be included in the basket. We think the following three hurdles are key:
- Representative exchange rates: having a representative foreign exchange rate matters a great deal for valuing the SDR portfolio. Currently there are three reference rates for the RMB: the fixing (or central parity) rate, CNY spot (onshore) and CNH spot (offshore). Unfortunately, all three rates have imperfections. The fixing rate is an official-determined rate – not a market-based rate. The CNY rate is relevant for onshore transactions, which only apply to investors with access to the mainland markets. The CNH spot is widely used by offshore investors, but on occasions, it could deviate significantly from the onshore rate.
- Suitable interest rates: given China is still at an early stage of developing a complete and liquid yield curve, choosing the most suitable interest rates for the SDR portfolio is no easy task. The Report recommends the three-month sovereign yield as the primary reference rate, but indicates that liquidity in the secondary market can be thin compared to mature markets.
- Hedging instruments: despite recent efforts to develop the CNY derivative markets, the number of instruments is still limited and market liquidity is thin. In comparison, hedging instruments in the offshore CNH market are more diverse with better liquidity. But given the occasional large deviation between the CNY and CNH, the latter cannot be a perfect hedge for CNY-based exposures.
- Notwithstanding these hurdles, the Report did highlight a number of recent efforts by the Chinese authorities to address the operational difficulties. These measures, in their view, could improve market conditions going forward.
- The proposed delay on the new basket implementation is driven by operational considerations. Given the possibility of having a new currency in the SDR, where the new basket will be effective on 1-Jan-2016, there is an operational difficulty to rebalance the portfolio at the start of the year, when market liquidity tends to be After consultations with SDR users, the Report has proposed to extend the current basket until September 2016. The Report made it clear that this proposal “does not in any way prejudge” the timing and the outcome of the Review.
Overall, after studying the document, we actually sense a positive vibe from the IMF on the RMB’s inclusion in the SDR. The positive discussion on the RMB being more “freely usable”, recognition of the government’s efforts to liberalize the capital account, and a “considerate” extension on the new basket implementation all seem to confirm our view that the RMB stands a good chance to enter the SDR this year. That said, although the IMF’s endorsement is important, it’s worth remembering that the actual voting on the SDR, which requires a 70% majority at the executive board, will likely be more political than economic. This makes the IMF’s support a necessary but not sufficient condition for the RMB to cross the finishing line.
On the exchange rate: given that our view on the RMB’s SDR inclusion has not changed, we think the most likely path for the exchange rate (the central fixing rate) will remain one of stability in the coming months. However, the recent People’s Bank of China report has aroused expectations of a band-widening in the near-term. If the CNY/USD trading range was to broaden to +/-3%, we would expect the spot rates to move quickly towards the top-end of the trading band (e.g. close to 6.28). This move could yield two benefits for China: 1) a weakening of the currency that supports growth and inflation; and 2) further FX reforms that give more price-setting power to the market.
On capital account liberalization: we do not think the official strategy to liberalize the capital account will be affected by this Report, particularly given our view that the timing of the SDR decision has not changed. We think the authorities will continue to roll out measures in H2 to make the onshore markets more accessible to foreign investors. But given the recent stock market turmoil and its damage on investor confidence, the authorities may be more cautious on the sequencing of liberalization between inflows and outflows.