22 October 2016
China's currency could face a modest depreciation risk after it is included in the IMF's reserve currency basket. Photo: Bloomberg
China's currency could face a modest depreciation risk after it is included in the IMF's reserve currency basket. Photo: Bloomberg

How will RMB move after IMF announces its SDR decision?

The International Monetary Fund (IMF) is expected to announce Monday the inclusion of China’s renminbi in the fund’s special drawing rights (SDR) currency basket. It’s almost a done deal. The move will have significant impact on China’s economy in the long run.

However, each coin has two sides. The market might witness a backlash if the weighting of the Chinese unit falls short of expectations.

Nevertheless, global central banks will start adding the Chinese currency yuan into their reserves after the redback joins the SDR basket. The moves will be made in an orderly manner in the next three quarters.

Now, will the inclusion offset market concerns about the Chinese unit’s depreciation?

The IMF has lowered the hurdle for board approval as a 70 percent voting majority is needed rather than 85 percent. US has a 17 percent voting stake, and Japan has 6.1 percent. So even if both the US and Japan reject the inclusion, China can still secure 70 percent vote.

The SDR is a type of international reserve asset that the IMF created in 1969. Countries are allocated SDRs in proportion to the IMF quotas they pay. They can use SDRs to make payments for future quota increases, to settle debts they owe to the IMF, which uses SDRs as a system of account, or to rebalance their reserves.

Holders of SDRs can exchange them for currencies that make up the basket, through deals with other SDR holders. Currently, the value of an SDR is based on a basket of four currencies — US dollar, the euro, pound sterling, and Japanese yen. The make-up and weighting of different currencies in the basket are adjusted every five years.

Investors are justified in wondering whether the renminbi will appreciate or depreciate after its inclusion in the SDR basket. 

It will be wrong to conclude that SDR inclusion will mean a sudden demand spike for the Chinese currency.

The actual demand will still depend on China’s capital account liberalization and progress of its exchange rate reform, as well as available investment choices of RMB-denominated financial instruments.

The prospects of the Chinese unit becoming a major reserve currency hinges on the nation’s reforms and economic growth.

Once the SDR inclusion is done, the Chinese central bank may not be able to intervene in the foreign exchange market easily to support the redback as it has been doing previously.

The currency might face more downside, and China could face even faster capital outflow. A considerable portion of the capital outflow is used for repaying corporates’ foreign currency debt.

In this case, investors should be wary of modest depreciation risk of the renminbi after it joins the SDR basket.

It’s estimated that around 600 billion to 700 billion yuan of capital will flee the country after the SDR inclusion. This capital will have significant impact on asset allocation, renminbi internationalization and the offshore renminbi market.

Global central banks will hold at least 1.5 percent of their reserve assets in renminbi, which will lead to 570 billion yuan of fund outflow.

This article appeared in the Hong Kong Economic Journal on Nov. 30.

Translation by Julie Zhu

[Chinese version中文版]

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Senior investment banker

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