RMB’s Inclusion Could Spark Big Reshuffle

The inclusion of the renminbi in the currency reserve basket is only a matter of time. It could trigger a US $1 trillion re­allocation of global reserve portfolios.

Before the summer, investment banks estimated that, in the medium-term, at least US$1 trillion of global reserves could switch into Chinese assets when, and if, the International Monetary Fund endorses the renminbi as a reserve currency.

However, a few weeks ago, the IMF recommended a delay of the inclusion. When will the IMF include the yuan in its basket and what will be the impact of that decision?

The IMF’s two-step tango

The IMF debate involves the review of its Special Drawing Rights (SDR). Cre­ated in 1969, the SDR is an international reserve asset, which today includes four major currencies: the US dollar, euro, British pound and Japanese yen.

China’s first effort to have the yuan included in the SDR basket took place at the previous IMF review in 2010. That attempt failed, due to inadequate capital account convertibility.

After half a decade, the Chinese gov­ernment has made the liberalization of the capital account and the exchange rate a major priority. however, even if the liberalization is completed in due time, the inclusion is not automatic.

The IMF review consists of two steps. The first step requires that the currency country is a major trading nation. Today, China is the world’s largest exporter and second-largest importer. However, the currency should also be “freely usable.” In China, some capital account restric­tions do remain. however, reforms are accelerating and in april the chief of the People’s Bank of China Zhou Xiaochuan vowed to make the yuan capital account convertible by the “end of this year.”

Full convertibility is not an explicit IMF requirement. For instance, the Japanese yen was seen as freely usable already in 1978; two years before Tokyo eliminated its foreign exchange controls.

The second step requires a final vote by its board. In practice, the renminbi needs a 70 percent majority in the final vote to become a reserve currency.

In early august, the IMF was asked to delay its yuan inclusion until September 2016. But even if China misses the cut in fall 2015, there is a high likelihood of an interim review that will grant the yuan SDR status before 2020.

What does it all mean?

RMB’s inclusion impact

In the near-term, the yuan’s inclusion in the IMF reserve currency basket may be small. It would involve the reweighing of the IMF’s SDR basket, which amounts to almost US$30 billion. Currently, the US dollar accounts for 42 percent and the euro for 37 percent of the total, whereas the British pound and Japanese yen are about 9-11 percent each.

However, the long-term consequences of the yuan’s inclusion would be huge.

An endorsement by the IMF could unleash a significant, though gradual, reweighing of the entire global reserve portfolio, which today amounts to some US$11.6 trillion. It is also likely that non-public, private investors would follow in the central banks’ footprints, especially as China’s capital markets grow more efficient and liquid.

If, initially, the renminbi would be 10 percent of the IMF reserve currency bas­ket, along with Japanese yen and British pound, then the position of the US dollar could decrease to 38 percent and the euro to 34 percent, respectively.

Assuming the global reserve portfolio would mimic these shifts, some 10 per­cent of the global reserves — more than US$1.1 trillion — could flow into yuan assets. That would herald a new era in the global capital markets.

The yuan’s adoption as a major reserve currency is now a matter of time. In the short-term, it means increased volatility. In the medium-term, it has potential to support China’s rebalancing and thus growth prospects globally.

Dr. Dan Steinbock is research director of international business at the India, China and America Institute (USA), a visiting fellow at the Shanghai Institutes for International Studies (China) and at EU Center (Singapore). For more, see http://www.differencegroup.net 

This commentary was originally released by Shanghai Daily on Sept 15, 2015