Yuan IMF Reserve Nod Either Worth $1 Trillion or Just Symbolic

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  • Inflows depend on economic fundamentals and reforms: JPMorgan
  • SDR entry won't mean much until capital controls eased: Daiwa

The yuan’s coronation as the International Monetary Fund’s fifth designated reserve currency will be either worth more than $1 trillion in fund inflows or little more than symbolic, depending on how quickly China opens its markets.

QuickTake The People’s Currency

The International Monetary Fund will need to conclude that the currency is "freely usable" for it to win entry in a review of the Special Drawing Rights basket this month. Standard Chartered Plc predicts the endorsement will draw between 4 trillion yuan ($628 billion) and 7 trillion yuan of funds over five years, up to half of which will come from reserve managers and the rest from private investors. Daiwa Capital Markets says that, until reforms make more progress, entry will be "almost irrelevant.”

Fund managers may favor currencies such as the Swiss Franc and the Aussie dollar until China can lift capital controls and improve its opaque and relatively illiquid markets. In the Communist Party’s development plan for the next five years, President Xi Jinping pledged to boost yuan convertibility and open up the financial industry to win SDR inclusion. Yet caution may prevail after a shock yuan devaluation in August triggered a record exodus of funds, amid a slowing economy and a volatile stock market.

“We believe the market’s confidence in the yuan will grow because of SDR, but this is a medium- to long-term process," said Zhu Haibin, chief China economist at JPMorgan Chase & Co. “It depends on China’s economic fundamentals and the progress of financial-market reforms, such as the diversity and liquidity of products. The infrastructure must be built well.”

IMF representatives have told China that the yuan is likely to enter the basket soon, Chinese officials with knowledge of the matter said in October. SDRs, which amounted to about $280 billion globally as of September, are claims that can be converted into any of the basket’s currencies.

Optimists say the endorsement will bolster the case for official and private managers to buy Chinese debt. Deutsche Bank AG predicts up to 4 trillion yuan of inflows and AXA Investment Managers $600 billion. This compares to about 44 trillion yuan of outstanding Chinese onshore bonds, fewer than 2 percent of which are held by overseas investors. With such a low base and further easing of limits on foreign buying, Goldman Sachs Group Inc. projects overseas investors could pour $1 trillion into Chinese debt in the "coming years."

Swissquote Bank SA expects the yuan to rise to 6.25 a dollar by June 30 on the SDR inclusion. Other banks are less bullish, with HSBC Holdings Plc and Standard Chartered predicting it will end the year at 6.5, weaker than the price of 6.3717 as of 11:15 a.m. in Shanghai. HSBC’s end-2016 forecast is 6.6, Deutsche’s is 6.7 while Daiwa’s is 7.5.

Apart from the potential IMF endorsement, investors will be drawn also to the country’s interest rates, which trump those of major developed nations. China’s 10-year sovereign yield is at 3.14 percent, compared with 2.32 percent in the U.S. and 0.61 percent in Germany.

Low Turnover

Among the major reasons why these factors haven’t already drawn a flood of investment are the capital controls and a lack of secondary activity. While China’s bond market is the world’s third-largest, annual trading as a ratio of total outstanding debt is 1.1, compared with 4.7 in the U.S., according to Bloomberg calculations.

“Hopes for a flood of capital into the yuan after SDR entry look misplaced: we are much more likely to see a trickle,” Michael Every, head of financial markets research at Rabobank Group in Hong Kong, wrote in a report. "China is a massive economy but does not yet have the deep, liquid, trusted financial markets that the U.S., Europe, the U.K. and Japan offer."

Challenges Remain

The absence of a developed and reliable ratings industry muddies the waters as well, with few defaults and upgrade-happy ranking companies making it difficult for foreign investors to assess credit risks. Also, private funds still have to apply for quotas to invest in onshore markets, while similar limits on global central banks were lifted in July.

The People Bank of China has taken a series of other steps to satisfy the IMF’s “freely usable” criterion. It has made the yuan’s daily fixing more market-driven, allowed central banks and sovereign funds to trade interbank bonds without pre-approval and sold its first-ever overseas debt in London. Obtaining SDR status could serve as a catalyst for further reforms, said Wang Ju, a currency strategist at HSBC in Hong Kong.

"If SDR inclusion can bring inflows to China, then the PBOC will be more than happy to liberalize some outward flows," said Wang. "SDR is one thing that some reformists will use to force the system to liberalize faster."

— With assistance by Tian Chen, and Fion Li

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