A Special Drawing Right (SDR) is an international reserve asset created by the International Monetary Fund (IMF) to supplement member countries' official reserve assets. The value of the SDR is based on a basket of four major currencies – US Dollar, Euro, Japanese Yen and the British Pound with the latest weights shown in the chart below. The weights of the currencies are based on their relative importance in world trade (based on the value of exports), as well as the prominence of the currency in terms of foreign exchange reserves held by IMF countries.
The composition of the basket is reviewed every five years and China has been actively campaigning for the inclusion of the RMB in the basket. The IMF is expected to decide on this by the last quarter of this year through a vote made by member countries. Nonetheless, IMF's Managing Director Christine Lagarde has confirmed that SDR inclusion for the RMB is more a matter of "when" than "if".
Figure 1. Latest IMF SDR Currency Weights (%)
Source: International Monetary Fund, Press Release dated November 15, 2010.
Why is the RMB being considered to be part of the SDR?
The two main criteria for SDR inclusion are (1) share in global exports and (2) currency is "freely usable" (as defined by the IMF). China clearly meets the first criterion as its share of total global exports in 2014 amounted to 12.5%, surpassing the US' 9%. The question on the "freely usable" criterion remains under debate, although we believe that given the progress that China has made towards currency liberalization, there is a high probability that the RMB will be included in the SDR basket this year.
Figure 2. US and China -Share of World Exports
Source: Nikko AM, International Monetary Fund, International Financial Statistics (IFS). As of June 2015.
The push for inclusion into the SDR has led to the acceleration of financial liberalization reforms. Targeted reforms to further increase RMB convertibility have been introduced. These include the opening of more offshore RMB clearing centres, increasing foreign access into onshore markets (QFII and RQFII), expansion of offshore investors by residents (QDII enhancements) and the widening of the currency trading band. Interest rate framework is also being reformed with the recent introduction of the deposit insurance system and the relaxation of deposit and lending rate caps.
So what are the potential implications for the bond market?
The inclusion of the RMB into the IMF SDR basket could potentially lead to significant flows into RMB-denominated assets. If included, this will be a move towards further internationalisation of the RMB -contributing to its increased use as an investment as well as a reserve currency. RMB appreciation would be an immediate impact, tempered by the fact that a lot of the positioning may be done ahead of the actual inclusion, and that access into the market is still via quotas, particularly in the onshore bond markets. The currency trading band may also be widened, increasing the volatility of the currency.
As a reserve currency:
From the reported weights in the world reserves data, there is currently only a small relative allocation to the RMB. One major global bank's report estimates that about US$ 70-120 billion of global central bank reserves are in RMB assets (equivalent to about 0.6-1% allocation). With the inclusion of the RMB in the SDR, allocation into the currency as a reserve would likely increase significantly.
Figure 3. Currency Composition of Official Foreign Exchange Reserves (COFER) World-Allocated Reserves by Currency (in percent)
Source: IMF Currency Composition of Official Foreign Exchange Reserves (COFER) data, as of Q4 2014. The data does not include unallocated reserves that consist of total reserves of non-COFER reporters and data discrepancy between reporters' data on total reserves as reported to COFER and to the IMF's International Financial Statistics (IFS). As of end-2014, 53% of world's total reserves of US$ 11.6 trillion are reported as allocated while the rest is unallocated.
Assuming inclusion, and that reserve managers increase their allocation of the currency towards a level similar to the JPY allocation of 4% in the next five years, this is equivalent to an allocation of almost USD500 billion (total reserve of US$ 11.6 trillion). This implies flows into the RMB bond market of approximately four to seven times the current estimated allocation.
This approach is simplistic but highlights the under-allocation of RMB bonds by reserve managers. Also, increasing openness should be supportive of reserve flows into the onshore bond market. Currently, foreign central banks and other institutions have direct quotas to invest in the onshore bond market as provided by the PBOC, separate from the QFII and RQFII quotas. Over 60 central banks have invested in RMB-denominated assets1. Latest quota data on this access route is not available, but the allocation by central banks would be increased as the market becomes more open.
As an investment currency:
Aside from central bank reserve allocation, we expect increased allocation by global bond investors into the onshore bond markets, depending on their quota access. As the quotas are increased and with a possible "bond connect" being implemented, we should see increasing foreign investor allocation into RMB bonds.
China's bond market is the fourth largest bond market in the world (with a size of US$ 5.3 trillion)2. As the regulators further open up the onshore bond market, the potential inclusion of China in global investment-grade bond indices will potentially generate significant inflows into the market. China government bonds are rated AA3 and AA-by Moody's and S&P, respectively. Although this would not be an immediate result of the SDR inclusion, accelerated relaxation of market access to China would increase its bond index weights in various bond indices that invest regionally or globally.
For global government bond indices and global emerging market bond indices, allocation to China bonds would also increase significantly. As improvements on market access warrants inclusion into the global benchmarks, global investors will subsequently increase their allocation. For example, based on market size, China's inclusion into global government bond benchmarks like Citigroup's World Government Bond Index (WGBI) may be around 5%. This is based on the current size of Citigroups's stand-alone China Government Bond Index relative to the size of the WGBI. Similarly, China allocation in global emerging market bond indices can also increase. Although index inclusion may not occur immediately, investor positioning towards this is likely to result in flows into the market.
Figure 4. Market Size of Select Countries in the Citigroup World Government Bond Index (WGBI) and the Citigroup China Government Bond Index
Source: Citigroup, as of 31 May 2015.
We estimate that foreign ownership of government bonds in China is still low at less than 2 percent, while other bond markets in Asia like South Korea and Malaysia are at 11% and 31%, respectively3. This means that there is still room for foreign investor allocation to China bonds.
So what would be the impact if RMB is not included in the SDR basket this year?
The IMF has been supportive of China's attempt to be included, but has not indicated that it recommends it. Furthermore, there is a risk that most of these reforms are too new for the IMF to judge whether they are effective or sustainable. Indeed, the commitment to maintain open and free markets often requires an economic cycle or two to judge fully, so the IMF may wish to wait for the next opportunity in five years. If so, given that the attention brought about by the potential SDR inclusion has already brought flows into China's onshore capital markets, failure to be included in the basket could lead to a short-term sell-off, although we believe that the momentum for investing in the Chinese bond market remains. The non-inclusion could slow down the potential flows but not necessarily lead to net outflows. After all, China's bond market is of significant market size, a potential portfolio diversifier which provides relatively higher yields than most developed bond markets. Market reforms are ongoing in the onshore bond market – increasing its suitability for global investor allocation.
- Standard Chartered -Global Research, June 2015.
- AsianBondsOnline, Asian Development Bank, as at end-March 2015.
- AsianBondsOnline, Asian Development Bank, as at end-December 2014.