The Door to China Swings Open

Inclusion of the Chinese yuan in the IMF’s basket of reserve currencies, expected to be approved at the end of this month, heralds China’s increasing presence in global capital markets. With its new status, the yuan will become more widely accepted in international transactions and more widely traded alongside the IMF’s other reserve currencies: the U.S. dollar, the yen, the euro and the pound.

Following internal studies by the IMF, Managing Director Christine Lagarde has fully endorsed the staff’s recommendation that the yuan be included in the basket of reserve currencies in the SDR (Special Drawing Rights), and the Executive Board is expected to approve its entry at a meeting on 30 November. In practice, the inclusion of the yuan should then take place in the second half of 2016, most likely in October.

The SDR is an international reserve asset created to supplement IMF member countries’ official reserves and serves as the unit of account for IMF quotas. Every five years, the IMF reviews the composition and weight of the SDR currencies based on two criteria: whether they represent major trading nations and whether the currencies are “freely usable.”

With China the third-largest exporter in the world, the yuan clearly meets the first requirement. The freely usable standard has been hotly debated. Still, the yuan’s usage is rising quickly in international payments, trade finance, the foreign exchange market and in central bank foreign exchange reserve management. It remains to be seen how far and how fast China really achieves full capital account liberalization.

For China, the inclusion of the yuan in the SDR is likely to be seen as a beacon for further reform, potentially driving more market-related structural reforms – especially in the financial sector. The “reward” for China will most clearly be seen in flows into the currency from the world’s central banks and sovereign wealth funds, which should alleviate some concerns over the potential for capital outflows going forward.

From an investment standpoint, we think that the yuan is likely to remain reasonably stable over the next quarter. However, given the changes made to the currency regime in August, there is more scope for the currency to adjust in value (weaken) over the next six to 12 months. The further out we look, the more we expect policymakers to allow the yuan to move in order to balance capital flows.

The inclusion of the yuan in the SDR is the key that opens the door to Chinese capital markets, in our view. Chinese equities are likely to enter global emerging market indexes over the next year or two (they already have the second largest market capitalization in the world). And the Chinese fixed income market, the third-largest in the world, is likely to become a major part of the global investor toolkit over the secular horizon, as local market access for foreign investors continues to expand.