16 February 2019
China needs a much deeper financial market to accommodate potential capital inflows as the renminbi becomes more internationalized. Photo: Reuters
China needs a much deeper financial market to accommodate potential capital inflows as the renminbi becomes more internationalized. Photo: Reuters

What challenges lie ahead for China after yuan’s SDR inclusion

Since Oct. 1, the Chinese renminbi has been officially included in the International Monetary Fund’s Special Drawing Rights (SDR) basket, a landmark event in China’s financial reform.

Chinese authorities have made enormous efforts to reach the milestone.

The government has improved cross-border renminbi settlement and currency swaps, established offshore renminbi centers and facilitated renminbi flows since 2009.

It has also made great progress in the use of the currency for trade settlement.

Authorities have adopted a series of measures to offer unlimited access for IMF member nations to onshore foreign exchange and fixed-income markets before the SDR review last year.

China has also gradually expanded the disclosure of its massive foreign exchange reserves portfolio.

China’s interest rate reform has achieved big progress since the official daily fixing reform in August last year.

The Ministry of Finance has started to issue three-month government bonds since fourth quarter of last year.

China also introduced the Cross-border Interbank Payment System (CIPS), which covers major time zones like Europe that have renminbi clearing demand.

Foreign sovereign investors are granted full access to the onshore interbank bond and currency markets.

The Chinese renminbi, also the yuan, will gradually become a major reserve currency after joining the SDR basket.

It will become more widely accepted and used in financial markets. Major central banks will add more renminbi assets to their reserves.

Meanwhile, IMF will push China to further accelerate the liberalization of its capital accounts and relax its tight grip on cross-border capital flows and currency convertibility.

To deepen the reform following the SDR inclusion, China needs to further adjust the foreign exchange rate mechanism and shift away from the currency’s traditional peg to the US dollar.

Since the SDR inclusion will boost the scale of the offshore renminbi market, the PBoC should give more consideration to offshore market response when making policy adjustments.

Currently, there are still technical obstacles for the renminbi to become a major international currency.

Its wider use requires abundant liquidity in offshore markets, which stems mainly from trade deficits, capital accounts liberalization, offshore yuan loans and international aid.

However, none of above channels is likely to provide sufficient liquidity in the short term.

China has to figure out how to solve such technical issues.

Ultimately, renminbi internationalization should facilitate capital flows in and out of China.

For instance, a mechanism to let nearly 2 trillion yuan (US$296.7 billion) of offshore yuan deposits to flow back to China will be needed.

Finally, there are around US$250 trillion of financial assets in global market. Suppose 5 percent is allocated to China, that would require US$12 trillion of mainland financial assets.

To cope with that huge amount of funds, China must develop a deep and open financial market.

Although there are already channels like the Qualified Foreign Institutional Investor scheme, Renminbi Qualified Foreign Institutional Investor scheme and stock connect programs, China still has a long way to go to catch up with the United States in this regard.

This article appeared in the Hong Kong Economic Journal on Oct. 19.

Translation by Julie Zhu

[Chinese version 中文版]

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