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Chinese Status Seekers

By Benjamin Shepherd on December 11, 2015

On Nov. 30, the executive board of the International Monetary Fund voted to finally add the Chinese renminbi to its Special Drawing Rights (SDR) basket of currencies. A sort of supranational currency, the SDRs are primarily used to bolster the international reserves of member countries and stabilize currencies in the time of crisis.

Basically, a currency in the basket becomes a “global reserve currency,” though in most cases that’s more a symbolic designation than anything, since it simply reflects that fact that the RMB is already commonly used in global trade.

Still, symbolism can have some practical consequences.

Most importantly, a currency included in the SDR basket must be freely usable and convertible. That basically means that the currency has been freely traded in the market, subject to at least limited to manipulation and anyone, anywhere can use it. Back in 2010, the IMF rejected the RMB for inclusion in the SDR basket precisely because it didn’t meet that criteria.

Anxious for the status associated with having a reserve currency, the Chinese have implemented a series of reforms over the past few years aimed at meeting those requirements. The country has opened up their stock and bond markets to more foreign investors and developed a deeper and more liquid foreign exchange market for the RMB.

The People’s Bank of China is also allowing entities more freedom to sell RMB-denominated debt in China, while easing limits on Chinese investment in foreign assets. Most importantly, it has been easing its grip on exchange rates, allowing the RMB to float more freely and loosening its peg to the U.S. dollar.

While the RMB won’t be officially added to the basket until October 2016, we’re already seeing the impact of the IMF decision. Just since Nov. 30, the RMB has depreciated by nearly 10% against the U.S. dollar, a pretty big move for the currency. Since the currency is likely to continue depreciating further from here, Chinese exporters should get a boost as their products become more competitive in the market.

And while estimates vary from forecaster to forecaster, asset managers at AllianceBernstein believe that China could see inflows of $3 trillion over the next few years while Morgan Stanley pegs it at closer $2 trillion. With China’s economy now worth about $10.4 trillion, either number isn’t exactly inconsequential and those inflows will provide a boost to asset values in the country.

Another important change on a similar front is that Chinese stocks could soon be included in MSCI indexes, some of the most commonly used investment benchmarks in the world.

Amazingly, major Chinese companies hadn’t been included in global indexes until just two weeks ago. Even now, only the 14 U.S.-listed Chinese stocks are included in global MSCI’s global indexes, with half added on Dec. 1 and the other half to be included on June 1.

To put that into perspective, there’s more than $9 trillion worth of assets indexed to MSCI’s benchmarks. Based on an estimate from Goldman Sachs, as much as $94 billion worth of those Chinese stocks may need to be bought for funds to match their indexes.

Given the magnitude of just that small change, consider the impact of the potential inclusion of all Chinese A-shares into MSCI’s Emerging Market Index. While MSCI has said China isn’t there yet and needs to make more progress on market liquidity and access, that progress probably will be made. The Japanese yen wasn’t generally recognized as fully convertible until two years after it was added to the SDR, and it was some time after that before its markets were fully open.

So the IMF’s decision to include the RMB in the SDR basket isn’t going to a have a huge immediate impact on the Chinese economy. That’s especially true is that decision is mostly just a reflection of economic realities in place, rather than just an arbitrary move simply to create an internationally important currency. But it has triggered an evolutionary process which will bring greater integration of the Chinese economy with the rest of the world and boosting China’s economic clout over time.

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