Credit: Shutterstock photoOnce every five years, the International Monetary Fund (IMF) reevaluates an obscure feature of international finance, the Special Drawing Rights (SDR). This basket of reserve currencies has consisted of the US dollar, the euro, the yen and the British pound since 1999. Investors are paying attention this time because the IMF is likely to add the Chinese yuan renminbi (CNY), marking a symbolic triumph for Beijing and a milestone in the transition to a new global economic order. The decision is expected at some point in November, though it could be delayed till early 2016, and would not take effect till October 2016.
What is the SDR?
The SDR is something between a line of credit and a currency; it was created by the IMF in 1969 in order to facilitate global liquidity. The value of one SDR, which the IMF and some other international organizations use as a unit of account, was initially pegged to the dollar at a one-to-one ratio, meaning it was in turn pegged to the price of gold. Following the collapse of the Bretton Woods fixed exchange rate regime a few years later, the SDR was reworked as a basket of 16 currencies. In 1981, that basket was pared down to the US dollar, the yen, the pound, the French franc and the Deutsche mark. These last two were replaced by the euro in 1999.
What does the SDR do? In theory, its purpose is to provide a way for member countries to obtain foreign reserves. The IMF allocates a certain number of SDRs to different countries based on the strength of their reserves. Countries with weak reserves may trade SDRs for other countries’ hard currency, either through voluntary bilateral agreements or IMF “designation.” To ensure that SDRs maintain some value, countries holding SDRs in excess of their allocation receive interest, while countries holding less than their allocation pay interest.
That sounds like a nice way to bolster individual countries’ monetary stability as well as global liquidity, and so it might be if the amounts involved weren’t—in the IMF’s own words—“insignificant.” From 1984 to 2008, holdings totaled around SDR 21.5 billion, ranging from $21 to $34 billion, depending on the exchange rate. In 2009, the financial crisis prompted an increase in SDR holdings to a little over 200 billion, worth $286 billion at the end of September 2015. That’s smaller than Facebook Inc (FB).
Joining the reserve currency basket alone will not send redbacks flooding across borders. China already engages in currency swaps as large as anything the SDR might enable. The People’s Bank of China (PBoC) reports CNY 4641 billion ($731 billion) in bilateral swap lines since 2011. In short, inclusion in the SDR is offers symbolic, not practical, advantages.
Is the yuan ready?
But symbols matter, and recognition as a reserve currency is itself dependent on criteria that illustrate the yuan’s growing clout. The first, “gateway” criterion is world export share. By IMF measurements, China was the world’s third largest exporter in the five years to 2014, as it had been in the previous period.
When the IMF last reviewed the SDR basket in 2009, the yuan did not make the cut because it did not meet the second criterion, that of being “freely usable.” The IMF defines a freely usable currency as “widely used to make payments for international transactions and […] widely traded in the principal exchange markets.”
In August, the IMF released a report on the yuan’s progress towards this goal. A survey of member countries’ official foreign assets (OFAs) showed that 38 countries held SDR 51 billion worth of yuan in 2014, or 1.1% of total OFA. That was up from 0.7% in 2013, when 27 countries held SDR 29 billion, but the yuan still lagged behind the Australian dollar and the Canadian dollar. The yuan also lagged in international debt securities, ranking 8th in 2015, up from 14th in 2010.
The report noted that “the rise of the RMB is the most significant development in international currency use since the last review,” but emphasized a lack of data and expressed concerns about thin renminbi trading in North America. By most measures except for trade finance, it said, “the RMB generally ranks behind the four freely usable currencies.” The report did not state a firm conclusion.
Following the report, Beijing doubled down on reforms to demonstrate its commitment to the free usability standard. It allowed its currency to float freely—that is, fall—for a few days, before propping it back up and setting off a brief wave of panic. In early September the PBoC announced that it would allow foreign central banks to participate directly in the country’s currency exchange market. Later that month, Beijing allowed the Hong Kong units of HSBC Holdings plc (HSBC) and Bank of China Ltd (ADR: BACHY) to issue yuan-denominated bonds in China.
On October 6, SWIFT reported that the yuan had pushed the yen out of fourth place for global payments in August and accounted for 2.79% of the total. In August 2012, it had been in 12th place with a share of 0.84%. Most recently, on Friday, the PBoC ditched upper limits on the deposit rates banks can offer, the step in its liberalizing agenda it considered the “riskiest.”
The yuan’s trajectory towards an international currency is clear enough. Whether it’s there yet is doubtful, but probably not as important as the progress it’s already made. IMF members are unlikely to hold off until 2020: first, the case for inclusion will likely be clear by then, making past hesitation seem short-sighted; second, the founding of the AIIB has shown that Beijing is not as dependent on American-led institutions as it once was, and IMF members probably do not see alienating China as productive.
What happens if the yuan is included?
Let’s assume that the yuan does make it into the SDR, becoming its fifth component (replacing another currency is in theory possible, but highly unlikely). The demand generated strictly by trade in SDRs won’t be anything to write home about, but the IMF stamp of approval comes with side benefits.
Standard Chartered plc (ADR: SCBFF) has estimated that over CNY 6 trillion ($945 billion) in offshore deposits could flow into the country by 2020, while renminbi invoicing for merchandise trade could reach $2.6 trillion per year. The bank estimates that the offshore renminbi market has grown 21-fold since 2010. AXA Investment Managers forecasts a migration into yuan-denominated reserves of over $1 trillion.
Source: IMF
Not everyone is convinced. Patrick Chovanec, Managing Director of Silvercrest Asset Management and Adjunct Professor at Columbia University’s School of International and Public Affairs, argues that in order to promote use of the yuan, China would have to export currency, when in fact it’s been importing trillions of dollars’ worth of others’ currency. Even if the country did attract panda bond investors, he argues, they would simply be exchanging their currency, much as tourists do, and the net flows would not change.
Yet China is poised to become a net exporter of capital, as outbound investment exceeds inbound investment. This net outflow, if it exists yet, is small, and slowing growth and falling commodity prices could alter the equation. Still, the idea that Maos will never mingle with Benjamins in forex traders’ accounts, central banks’ coffers and inflation-stricken mattresses (Zimbabwe is a pioneer in this regard) requires a pretty stubborn outlook.
Gaining exposure to the renminbi
For investors looking to play a potential appreciation in the value of the yuan, choices include the WisdomTree Chinese Yuan Strategy ETF (CYB) and the Market Vectors Chinese Renminbi/USD ETN (CNY). Note that the latter is an ETN, technically making it a debt security. The Guggenheim CurrencyShares Chinese Renminbi ETF (FXCH), another option, is very thinly traded, averaging just over 500 trades per day in the last three months. CYB and FXCH are shortable; CNY is not.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
