Will its inclusion have a significant impact on global capital flows, exchange rates and the price of treasury assets? In the short to medium term, almost certainly no, although we do believe that over the longer term, the RMB is highly likely to achieve reserve currency status. The question now is should investors be worried about this?
The predominant reasons for China seeking inclusion are as much political as they are economic. SDR inclusion became a matter of patriotic pride for the Communist Party, a matter of international policy and a bid to reassert itself on the global stage. Insofar as the IMF has shown that its financial architecture is receptive to shifts in the global financial powerbase, the inclusion of the RMB is a positive step.
The economic reasons for seeking inclusion relate to establishing the RMB as a reserve currency. Reserve currencies have much more stable exchange rates and lower portfolio flow volatility. This would allow Beijing to continue to pursue financial liberalisation with less fear of significant financial outflows, as it relaxes restrictions on capital. Yet becoming part of the SDR basket is very different to achieving reserve currency status.
The SDR basket is not an asset allocation for sovereign reserve management. Reserve managers will now need to hedge their implicit exposure to the RMB from their holdings of SDRs, but they are under no obligation to use the RMB as a reserve currency. And given the ongoing uncertainty surrounding how Beijing will control the exchange rate over the next few years, it is rather unlikely that they will start to stockpile more RMB just because of the IMF’s announcement.
There has been nothing to stop reserve managers buying RMB to date, so what’s changed now? The impact from the aforementioned hedging activity will be negligible too. Total SDR allocations amount to $286bn, so even if we assume the IMF announces RMB inclusion at 10% of the basket, this would equate to just a fraction of the monthly RMB turnover due to trade.
Over the longer term, the RMB is highly likely to achieve reserve currency status – notwithstanding that a large, liquid and, most importantly, open, fixed income market is a necessary precursor – and this will lead to hundreds of billions of reserve managers’ dollars flowing into the RMB, at the expense of the USD, GBP, Euro, Yen and gold.
Yet this will only occur as part of the process of broader financial liberalisation. And economic theory and historical precedent firmly suggest that far more capital will flow out of China (seeking yield and diversification) as part of this process than foreign capital will flow in, even if reserve managers are on board.
Global investors must assess these net changes, not the isolated impact of various parts of the process, and for this reason speculation over China and the RMB sucking up liquidity and derailing Western financial markets looks wildly overblown.
