FX Watch – A Q&A on the yuan’s SDR inclusion

by: Roy Teo , Arjen van Dijkhuizen

150622-FX-watch-A-QA-on-the-yuans-SDR-inclusion.pdf (88 KB)
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  • In late 2015, the IMF will decide on the composition and valuation of the SDR basket. In the last SDR review in 2010, the IMF concluded that the CNY did not meet the criteria of being a freely usable currency.
  • In our view, the likelihood that the CNY will qualify for SDR inclusion has risen compared to 2010, given its increased use in global trade and finance. In fact, as confirmed by the IMF, SDR inclusion is more a matter of ‘when’ than ‘if’.
  • Still, we have doubts about whether SDR inclusion will already take place this year, as the IMF might want to see more progress (or more commitments) regarding the liberalisation of the capital account and the exchange rate regime. However, in case of a ‘no’ this year, we do not think that China would have to wait for another five years per se.
  • The yuan inclusion in the SDR basket is not expected to have material impact on our slightly bearish view on the yuan

 

 

 

Background

In late 2015, the Executive Board of the IMF will decide on the composition and valuation of the Special Drawing Right (SDR). According to IMF regulation, the currencies and their weights in the SDR valuation basket are reviewed every five years, unless the Board decides otherwise. At the last SDR review in 2010, the IMF concluded that the CNY did not meet the criteria of being a ‘freely usable currency’.

China has already been aiming for years to get the yuan included in the SDR basket, as it wants to support the globalisation of the currency and strengthen its economic and geopolitical clout. The authorities hold the view that SDR inclusion would facilitate the further use of their currency in foreign trade and finance. China has even set a formal target for inclusion of the yuan in the SDR for this year.

What are the criteria for inclusion in the SDR basket?

The IMF Special Drawing Right (SDR, see box 1) basket consists of the four major traded currencies. The criteria as determined by the IMF for SDR basket composition are:
1) the size of country’s exports of goods and services during the five-year period ending 12 months before the revision date:
2) the currency must be ‘ freely usable’. According to the IMF’s Articles of Agreement, a freely usable currency is a member’s currency that the Fund determines a) is widely used to make payments for international transactions and b) is widely traded in the principal exchange markets.

During the last review in November 2010, the IMF Board concluded that “although China has become the third-largest exporter of goods and services on a five-year average basis and has taken steps to facilitate international use of its currency, the Chinese renminbi does not currently meet the criteria to be a freely usable currency and would therefore not be included in the SDR basket at this time”.

Is there a case for CNY to be included in the SDR basket?

Yes. In our view, the yuan has come closer to meeting the criteria for SDR inclusion. We would like to highlight that determining whether a currency is ‘freely usable’ remains a matter of subjective judgment.

Still, referring to the criteria mentioned by the IMF, there are some observations to be made showing that the yuan’s role in international trade, payments and finance has increased sharply since 2010 (see Box 2 for more details):
– The number of central banks that invest in the CNY has risen to around 60, while the PBoC has currency swap arrangements with 30 countries;
– According to the BIS, the CNY is now the 4th largest currency in international money market instruments.
– Regarding the denomination of international debt securities, the CNY is ranked 9th and its share is expected to rise further in the coming years.
– In terms of daily FX market turnover, it is expected that the CNY will rank number 5 in 2016 (after the four currencies currently included in the SDR basket).
– The CNY is also the 5th most active used currency globally in global payments in April 2015, according to SWIFT, after the four SDR basket currencies.

Is CNY inclusion in the SDR basket likely in 2015?

We have some doubts. We believe there is a high likelihood that the yuan will be included in the SDR basket in the coming years, but it is hard to tell currently whether that will already occur this year. IMF Managing director Lagarde and other key officials have recently stated that RMB inclusion is a question of ‘when, not if”. During a recent G7 meeting, German Finance Minister Schaüble stated that ‘we are in full agreement on the goal, but it would not be good to rush it’. It may well be that the IMF Board, partly influenced by the US, will ask China to further liberalise its exchange rate regime and its capital account as a precondition for yuan inclusion in the SDR basket.

The basket composition is in principle reviewed every five years by the Executive Board, but mind the additional phrase ‘unless the Boards decides otherwise’. We think that should the yuan not be included in this year’s review, China would not need to wait for another five years to be included.

Can the US veto the CNY inclusion in SDR basket?

No. A 70% voting approval is needed to incorporate a currency into the SDR while other decisions require 85% approval by IMF member states. Hence, the US with about 17% of voting rights does not have the veto power to the yuan being included in the SDR basket.

Will CNY internationalisation profit from SDR inclusion?

Yes. While inclusion of the yuan in the SDR basket would facilitate the further use of the currency in international trade and finance, this issue is partly symbolic. There are smaller currencies such as the Swiss franc, which are not included in the SDR basket but have a global reserve currency status. Still, although inclusion of the yuan in the SDR basket is not a pre-requisite of being a reserve currency, it would support its further use in international trade and finance, as it would make the yuan a more internationally recognised currency and enhance its status as reserve currency. It will also make the SDR basket more representative of global trade and enhance the stability of the SDR basket given the yuan’s low correlation with the US dollar and euro.

What steps is China taking in the meantime?

With an eye on possible yuan inclusion in the SDR basket, the Chinese authorities stated earlier this year that they aim to achieve yuan convertibility under the capital account, even though full currency convertibility is not a prerequisite for SDR inclusion. The authorities have already made some steps towards financial liberalisation, such as setting up a long-awaited deposit insurance system and grant more freedom to set deposit rates. However, the authorities will probably keep on managing the opening up of the capital account carefully, given the potential systemic risks attached to it.

Still, PBoC governor Zhou has referred to changing regulation regarding exchange rate controls, the liberalisation of both inward and outward-bound investment and the opening up of bond, equity and other financial markets to foreign investors. Earlier this month, the PBoC published a report on yuan internationalisation, announcing some measures to promote capital account liberalisation and yuan convertibility. The authorities want to stimulate foreign institutions (beyond central banks) to invest in China’s interbank bond market and to issue CNY bonds and allow more Chinese institutions to borrow CNY overseas and ease the restrictions on CNY bond issuance.

Would SDR inclusion impact our yuan view?

We do not think that the inclusion of the yuan in the SDR basket will materially change our slightly bearish view on the yuan. An increase in central banks’ demand for the yuan as a reserve currency will be small (the SDR quota represents less than 3% of total global reserves) and gradual. We see a risk of potential net outflows from China as domestic investors seek opportunities abroad as the capital account will be gradually liberalised. We also expect some weakening of the yuan as a result of the widening divergence in monetary policy between the US (we expect the Fed lift-off in September) and China (we expect ongoing measured monetary easing to keep growth close to the 2015 target of 7%). Furthermore the currency is no longer undervalued and a weaker exchange rate will help to support exports which has been weak since the beginning of this year. On balance we maintain our 2015 and 2016 year end yuan forecasts of 6.30 and 6.40.

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