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November 19, 2015

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Implication of yuan’s coming inclusion in SDR

IT is now just a formality issue for the yuan to be included in the special drawing right. This will not trigger an immediate global asset reallocation, but the impact could be gradual, long-lasting and significant in the long run. We expect the local currency to stay within the range (around 6.40 against the US dollar) in the next few months.

The International Monetary Fund’s Managing Director Christine Lagarde issued a statement and announced that IMF staff recommended the Chinese currency to be included in the SDR, and the board decision will be made on November 30.

The decision is not surprising. In line with what we have pointed out, the IMF statement said “IMF staff assesses that the yuan meets the requirements to be a ‘freely usable’ currency” (and the export criterion has been met long time ago), and “Chinese authorities have addressed all remaining operational issues identified in an initial staff analysis.”

The final decision from the Executive Board on November 30 is unlikely to deliver surprise.

Almost all major voting members (even the United States and Japan) have explicitly supported yuan inclusion in the SDR “on the condition that it meets the requirements.”

Now the IMF assessment report will suggest an unconditional yes decision in the board meeting, and the yuan will join the US dollar, euro, British pound and Japanese yen as the fifth SDR basket currency.

A favorable decision on yuan inclusion in SDR will not trigger immediate capital inflow into yuan assets.

First of all, the new SDR basket will not be effective until October 1, 2016 (to allow sufficient lead time for the basket adjustment).

There are three possible channels that the SDR basket currency label could affect capital flows.

First, the automatic adjustment in SDR-denominated assets, assuming that yuan will receive a weight of 14 percent to 16 percent in the new SDR basket as the IMF initial assessment report has suggested, will imply about US$40 billion to be linked to yuan.

However, this is only an accounting change, not real transactions. Holders of SDRs can obtain yuan in exchange for their SDRs in two ways, either through voluntary exchanges between members or via the IMF designating members with strong external position to purchase SDRs from members with weak external position.

Second, the role of yuan in global reserve assets could rise.

The yuan is under-represented in global foreign exchange reserves (around 1 percent).

Reserve managers will gradually increase the holding of yuan-denominated assets, possibly reaching 5 percent (or a net inflow of US$350 billion) in the next five years.

Third, global asset allocation decision of real money managers are more likely driven by interest rate differentials, currency expectations, and whether yuan assets will be included in major stock/bond indices. In the current market environment, a favorable SDR decision is unlikely to lead to an immediate change in China’s capital flow dynamics.

Nonetheless, the impact could be gradual, long-lasting and significant in the long run.

The official endorsement from the IMF that the local currency is a freely usable currency has important implications, and it will support China’s financial reform going forward, in our view.


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