China’s slippery SDR sanctification

Chinese financial markets continued their comeback as the IMF staff set the stage for yuan inclusion in the Special Drawing Rights artificial basket.

yuan noteThe inclusion comes with a technical “freely usable” finding for international currency and trade transactions, despite capital controls due to last through end-decade under the latest 5-year economic plan. Managing Director Lagarde endorsed the report, and IMF board acceptance at end-month will be a formality with US support triggering an entry timetable for late 2016.

The Treasury Department decision came in the face of its semi-annual assessment that the RMB was “below appropriate medium-term valuation,” as it acknowledged incremental flexibility and cross-border opening and moved to repair strained relations from Congress’ failure to pass IMF governance reform.

The preliminary SDR weighting should be ahead of the Japanese yen at around 15%, but foreign central bank reserve and investor capital market allocation will remain paltry for years without access and trading breakthroughs as in all other emerging economies that have historically been outside the synthetic “global currency.”

China’s central bank launched the admission campaign in the wake of the 2008-09 crisis to diversify dollar reliance, but with persistent GDP slowdown and foreign exchange outflows it is no longer in such a strong implementation position. The logic has shifted to financial sector reform impetus for overcoming current trade, investment and debt squeezes, and laying a foundation for modern banking and securities markets as in the rest of the region.

According to the SWIFT payments network, the yuan is only used for 2.5% of international commerce, and the BIS puts it behind the Mexican peso and other units as fractional components in foreign exchange dealing. The local stock and bond markets are valued at multiple trillions of dollars, but foreign investor participation is limited by quotas and operational and regulatory hurdles.

Index provider MSCI just raised China’s portion with Hong Kong of the core developing market benchmark to 26% from the previous 23% with the addition of overseas-listed firms like internet giant Alibaba.  However, the mainland exchange has experienced widespread suspensions and official intervention the past three months to further deter international players. The debt market in contrast has been partially liberalized for non-resident institutions, but their share is stuck under 2% as state-owned banks and enterprises dominate both buying and issuance with minimal secondary trading.

The main near-term post-SDR yuan inflow may come from central banks and sovereign wealth funds realigning holdings, with estimates in the $100 billion range annually. Yet this amount is negligible against the over $10 trillion in global reserves and China’s own $3.5 trillion stash. Managers also consider liquidity, safety and economic policy and performance factors outside the Fund’s basket formula for placement.

The Japanese yen has an 8% weighting but draws only half that allocation in the IMF’s regular survey of central bank preference, while the Swiss Franc is a major choice outside the SDR. Domestic banking system health is paramount and October figures showed a sharp credit drop as the understated non-performing loan ratio drifted toward 2%, despite interest rate and reserve requirement cuts. Under supply and demand constraints money supply expansion may be only single digits in 2016, as the GDP growth forecast was already pared to 6.5% in 2016. Debt defaults at both private and state firms in the energy, steel and cement industries reflect lingering overcapacity and deflation worries that cap the manufacturing PMI under 50, as the services sector is pressed to absorb the slack.

Exchange rate direction can now go both ways and basic stability cannot be assumed despite the SDR move. The RMB has recovered ground against the dollar but may slip again with a Fed rate nudge in December, and onshore and offshore rates continue to diverge. The authorities have begun to disclose limited reserve data but not interventions reportedly concentrated on the murky forward market. They are also studying the old standby of a Tobin tax to discourage “speculative” trading, when the emphasis should be on new convincing steps toward routine commercial dealing within established emerging market practice if the Fund’s conceptual maneuver is to inspire actual mainland makeover.

Gary N. Kleiman is an emerging markets specialist who runs Kleiman International in Washington, D.C.

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