China’s currency may be poised for steady appreciation ahead of historic IMF decision

Executive Summary:

  • China’s currency is eligible for inclusion in the Special Drawing Rights (SDR), a global basket of reserve currencies run by the International Monetary Fund (IMF)
  • Upon inclusion, every IMF member’s central bank will be required to hold China’s currency in reserve
  • We expect demand for China’s currency to spike as the IMF’s decision approaches

Since the financial crisis of 2008, China has been pursuing a policy of internationalization of its currency the renminbi (RMB). One of the most important milestones for the RMB’s ascent onto the world stage is its potential inclusion within the IMF’s Special Drawing Rights (SDR), a basket of reserve currencies. Upon its inclusion, every IMF member country’s central bank will be required to purchase RMB to hold in reserve. We predict there will be a surge in demand for China’s currency as a result. In order to potentially benefit from the inclusion, we believe U.S. investors should consider seeking RMB exposure ahead of the IMF’s decision in January 2016.

Overview of the SDR

  • The Special Drawing Rights (SDR) is a basket of reserve currencies established by the International Monetary Fund (IMF) to bolster reserves held by the central banks of its member countries.
  • The SDR system was created by the IMF to provide stability in the event of any shortfall in preferred foreign exchange reserve assets, namely gold and the U.S. dollar
  • Currently there are four major world currencies included in the SDR – the Euro, Japanese Yen, British Pound Sterling, and U.S. Dollar.
  • Every five years, the IMF reviews the status of currencies within the SDR and opens up a window for inclusion of additional currencies. 2015 is a review year, and China’s currency is eligible for inclusion.
How the SDR works

The IMF sets quotas for the number of SDR units (SDRs) countries must hold in their reserve banks. An SDR unit represents a basket made up of four major world currencies. Right now this unit is a blend of euros, yen, pounds, and dollars. SDRs can only be converted between member countries’ central banks in exchange for a single country’s currency. Member countries must report their reserve currency holdings to the IMF. If a country is found to hold fewer SDRs than dictated by their quota, they owe the IMF interest on the shortfall; if they hold more, the IMF pays them interest on the excess. The SDR quota only represents a small percentage of total global reserves, or $204 billion1 of a $7.2 trillion asset pool2. The SDR system has great potential as a stabilizing force in the global economy; however, due to the relatively small quota requirements enforced by the IMF, its practical utility is rarely exercised by developed nations. Instead it is relegated to just a unit of settlement within the IMF itself, except for trade transactions between the smallest developing member nations.

If it is not widely used, why is China interested in it?

The SDR is important, not for what it is today in the practical sense, but more for its regard as a status symbol and for what it might become in the future. China’s interest in the SDR largely began after the financial crisis of 2008 when China, the largest holder of U.S. dollar debt assets3, was greatly exposed to instability stemming from the United States. The Chairman of the People’s Bank of China, Zhou Xiaochuan, argued that no single credit-based currency should be a predominant reserve instrument and that the SDR had not been put into full play due to is limited allocation and scope. Mr. Zhou argued that if the SDR had greater practical use it could become a super-sovereign reserve currency. A more powerful SDR could not only eliminate the inherent risks of credit based single-country reserve currencies, but also make it possible to better manage global liquidity in times of crisis. The first step toward achieving Mr. Zhou’s vision is getting the RMB included in the SDR.

The inclusion process

Whether the SDR will become a super-sovereign reserve currency remains unclear. What is clear is that China’s leadership has a strong interest in getting the RMB included in the SDR during this year’s IMF review. SDR inclusion is determined through a vote by the 188 members of the IMF4. Countries’ voting rights are weighted by their relative position in the world economy. In order for the currency to be included, it needs to earn 77% of the votes4. The table below outlines the top ten countries by their number of votes.

Country% of total votes
United States16.75
United Kingdom4.29
Saudi Arabia2.80
Russian Federation2.39

Source: IMF as of 3/31/2015

Inclusion Requirements

The RMB was not included during the last review in 2010 because it was deemed to not meet “free usability” requirements. In addition, the IMF at that time did not want to jeopardize the stability of the four-currency basket. These two requirements were clarified by the IMF in a paper from 2011 titled: Criteria for Broadening the SDR Currency Basket. In the paper, the IMF defined “free usability” as a currency that is “widely used to make payments for international transactions” and “widely traded in the principal exchange markets”. The paper also said that the four-currency limit could be expanded as long as it didn’t jeopardize the “stability of the basket and representativeness of currencies.”

1.) Free usability

Internationalization of the RMB has progressed exponentially since the last IMF review of SDR basket composition. According to the Standard Chartered Renminbi Globalization Index, the RMB is now 20 times more internationalized than it was at the start of 20115, and 60 IMF member countries’ central banks now include the renminbi among their foreign reserves5. Free usability has been further expanded by the surge in the number of RMB offshore clearing banks, banks that allow people in countries outside China to clear transfers in RMB, and RMB bilateral swap agreements, a foreign exchange transaction that allows the exchange of principal and interest in one currency for the same in RMB.

Fourteen countries have established RMB offshore clearing banks including four of the top ten IMF countries by voting rights including: Germany, France, the United Kingdom and Canada6. Twenty-nine countries have established RMB Bilateral Swap Agreements including six of the top ten IMF countries by voting rights including the European Union (Germany, France, Italy), United Kingdom, Canada and Russia6.

2.) Effect on stability of the SDR basket

The IMF stated they would open the SDR up for inclusion of additional currencies as long as they didn’t jeopardize the stability of the underlying basket. Perhaps surprisingly, the RMB’s volatility over the last year is less than the euro, pound and yen.

It is unsure whether the U.S. will support the RMB’s inclusion in the SDR, as this could be perceived as a challenge to the dollar’s global reserve dominance. However, based on increasing international appetite for the RMB, it is likely there will be enough votes in favor of RMB inclusion regardless of U.S. votes. Inclusion in the SDR could spark widespread demand for China’s currency among central reserve banks. With $7.2 trillion currently held in global reserves, the inflow could be significant. Jukka Pihlman, Global Head of Central Banks and Sovereign Wealth Funds for Standard Chartered, may have put it best when he said that the inclusion in the SDR “could propel the renminbi into the currency stratosphere.”

We believe investors should consider taking a position in RMB-denominated assets before the IMF’s decision in January 2016. China’s currency moves will be widely followed ahead of the IMF review and its government wants to make sure it looks favorable in front of the committee. This should mean the RMB will be particularly stable up until the vote in January 2016, and should appreciate dramatically based on increased demand by central reserve banks leading up to its possible inclusion.

1.) IMF as of February 2015

2.) IMF as of January 2015

3.) U.S. Treasury Department as of January 2015

4.) IMF as of December 2014

5.) Standard Chartered as of December 2014

6.) Source Bloomberg as of March 2015

7.) Standard Charted RMB Internationalization Index:
The Standard Chartered Renminbi Globalization Index (RGI) aims to measure overall growth in offshore Renminbi usage. It is the first authoritative measure in the market to gauge the extent of Renminbi internationalization. The RGI is computed on a monthly basis, based on four CNH (CNH: RMB that is traded offshore, mainly in Hong Kong) market components with weights inversely proportional to their 24-month normalized standard deviations – (1) CNH deposits, (2) trade settlement and other international payments, (3) Dim Sum bonds and certificates of deposit (CDs) issued, and (4) FX turnover (FX: is short for forex, the market in which currencies are traded), all from an offshore perspective and denominated in Renminbi. Location-specific data for each component is used to compute a corresponding global aggregate. The index initially covered only Hong Kong; Singapore and London were added in August 2011, Taiwan was added in July 2013, New York in January 2014 and Paris and Seoul were added in August 2014. More centers will be added to the index as they become more significant

8.) Source Bloomberg as of 3/31/2014.
Standard Deviation: Standard deviation is a statistical measurement that sheds light on historical volatility. For example, a volatile stock will have a high standard deviation while the deviation of a stable blue chip stock will be lower. A large dispersion tells us how much the return on the fund is deviating from the expected normal returns.