October 2015

CHINESE RMB NEEDS TO BE A REGIONAL

CURRENCY BEFORE AN INTERNATIONAL
RESERVE CURRENCY
The year 2015 has been marked by two important developments in the China Story: 1) the
world (and China itself) finally fully discounted a slower growth trajectory, and 2) the failed SDR
Basket inclusion manoeuvre forced China to address in earnest its lagging commitment to financial
sector liberalisation.

While the first development was an ongoing saga that simply reached its

inevitable final-stage conclusion, the latter development initially caught many market participants
off-guard. The IMF regular 5-year SDR review exercise and formal rules-based procedures for
assessment were mostly unfamiliar to the market, which is a testament to the limited relevance of
SDRs in actually determining the hard currency preference of reserve managers around the world.
The SDR proportion of international reserves accounted for just 3% at the end of 2014 (IMF Annual
Report, Appendix I) and the IMF Currency Composition of Official Foreign Exchange Reserves
(COFER) currency basket distribution of currency holdings bears little resemblance to the SDR basket
weights (Graph 1).

Graph 1
Official Reserves: IMF COFER Basket

SDR Basket: 2010 Weights

Source: IMF, currency composition of Official Foreign Exchange Reserves survey. The Australian dollar and the Canadian dollar were not
separately identified in COFER surveys until 2013.

Nevertheless, in yet another unorthodox attempt to

The Author

circumvent the well documented, transparent, easy-tocomply-with path to full functionality within the Global
Financial System, China elected to try to lobby its way into
the SDR basket in spite of IMF Staff efforts to exhibit failure
to qualify. Indeed, the lobbying effort continues in earnest
as we approach the November IMF Executive Board meeting.
If one reads the IMF Staff July SDR Review Report, you are

Mark Farrington
MD, Head of Macro Currency
Group and Portfolio Manager

immediately struck by the patient, methodical and

comprehensive manner in which the Staff explained its rulebased methodology so that it was clear beyond a shadow of
a doubt that its methodology was not political, but rather
orthodox application of open financial market, economic
methodology. One can either conclude that the IMF Staff
was under tremendous political pressure from one of its

prominent Members, or it was conducting a perfect exercise in the education of a former socialisteconomic client on the workings of open economic and rules-based financial systems. In both
regards, the IMF Staff deserve an honour of merit for a perfect tutorial and diplomatic rendering. Its
conclusions were simple enough to follow:

In light of the relatively recent review by the Board, Staff does not propose to revisit the
currency selection criteria at this point. Recent developments suggest that the current selection
criteria have remained broadly supportive of the SDR baskets stability and its representativeness of
the use of currencies in international transactions.

Preliminary data shows that the RMB generally ranks among the highest of the non-freely
usable currencies. At the same time, the RMB generally ranks behind the four freely usable
currencies, with trade finance being a notable exception. The standing of the RMB under some
indicators will also be affected by data adjustments to address measurement issues involving Hong
Kong SAR, Macao SAR, and Taiwan Province of China. The RMB is now one of the most-traded
currencies in Asia and the share in Europe is rising but from a low level, while trading in North

America remains thin. More granular analysis suggests that the depth of FX markets for the RMB,
while lower than that of the four currencies that are currently freely usable, may have reached a
magnitude that could allow executing sizable transactions.
(IMF Method of SDR Valuation Report, July 2015, pp. 39-40)

While there is certainly more at stake as the November Executive Board convenes, and the
Staff did leave its indicator-based conclusion open-ended enough to allow for the Board to make a
judgement call, it is with some optimism that we can view the events of August as signals that IMF
credibility will be preserved. Firstly, the Exec Board accepted the Staffs recommendation to delay
rebalancing and modification of the SDR basket until September 2016, rather than the January 2016
start it would have normally seen. This decision was backed by operational feedback from IMF
Members, as well as recognising that a RMB inclusion in the basket would be much more than a
normal basket rebalancing exercise, and is something that no one would want to try to execute in the
illiquid period over year end / New Year. The second event that signals optimism that our rulesbased system will prevail was PBOCs decision to change its central parity (fix) methodology following
the publication of IMF Staff report in early August, which resulted in an onshore-CNY drop of 1.9%
(Graph 2). Essentially, Authorities stopped using their artificial morning fix to re-anchor onshore
trading to their directional preference, and instead now commit to incorporating market markers
quotes in their judgement-based fixing methodology. This was not a move to a free-float by any
means, but it was enough of a system change to result in net supply / demand pressures (both
offshore and onshore) to now determine the direction of the RMB. The IMF confirmed as much with
its Press Line announcement on 11 August that read;

The new mechanism for determining the central parity of the Renminbi announced by the
PBC appears a welcome step as it should allow market forces to have a greater role in determining
the exchange rate. The exact impact will depend on how the new mechanism is implemented in
practice.

Graph 2
CNY, CNH and the Fix

Source: Bloomberg, ANZ Research.

The IMF spokesperson also added important input on the SDR review process by noting;

We believe that China can, and should, aim to achieve an effectively floating exchange rate
system within two to three years. Regarding the ongoing review of the IMFs SDR basket, the
announced change has no direct implication for the criteria used in determining the composition of
the basket. Nevertheless, a more market-determined exchange rate would facilitate SDR operations
in case the Renminbi were included in the currency basket going forward.
(IMF Press Line on PBCs announcement on the change of the RMB fixing mechanism, August 11, 2015)

This response from the IMF is instructive on two points, firstly, the emphasis on achieving a
free-floating currency in two or three years sets the timeframe for justifiable inclusion in the SDR
basket, and secondly, clarifies that this bears no impact on the November review. This second point
can be true due to the fact that fixing methodology is not one of the four primary criteria for freely
usable methodology, or because it comes too late to produce any reliable indications of improved
usability. For sure the decisions to improve the fix, allow for a market determined exchange rate and
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additional decisions announced by the PBC on 30 September to improve access to onshore markets
for foreign Central Banks will greatly contribute to bolstering the criteria for freely usable.
Unfortunately, they will not show this impact on global international transactions statistics for several
years.

The fact that Chinese Authorities almost immediately began to take measures to address
some of the Staff concerns on clarifying how some indicators will be defined for purposes of an
assessment, suggests that private, preliminary feedback to China was that they still have much more
to do. The provision by China of COFER data to the IMF in the month of September for the first time
ever, albeit with confidentiality requests, can also be counted as evidence of responsiveness to IMF
procedural compliance for SDR assessment.

One of the essential points to take away from the IMF SDR Methodology Review is that
under the freely usable criterion the CNY is growing as a Regional currency, not an International
transaction currency. Nearly 80% of all of the growth in CNY/CNH use since 2010 has been between
the Mainland and Hong Kong, Macao and Taiwan. What could perhaps be claimed by China is that
Hong Kong, Macao and Taiwan increasingly operate, trade and save in CNY terms, which seem
perfectly logical given that they are deemed to be a single territory. The IMF Staff rightly cited the
already existing precedents for treatment of monetary unions and currency transactions within ones
own territory from the example of the methodology used for the euros inclusion in the SDR basket in
1998 and Chinas currency travel restrictions in 1999 (IMF International Transactions under Article
XXX(f), IMF SDR Review, Page 12). It was determined that these transactions between China and its
territories were not international transactions. Furthermore, the freely usable criterion is based on
transactions between IMF Members, and Taiwan, HK and Macao are not members. In addition to
the Greater China transaction usage, the second most significant sector or increased usage is Asian
Region; Korea, Malaysia and Singapore.

Graph 3
Cross-Border Payments
1/ (shares in percent of global total)

China lags behind on cross-border portfolio

investment (International investment position, %
of GDP)

Source 1: Staff calculations based on transaction values from SWIFT messages MT 103 and MT 202 excluding MT 202 COV.
Source 2: CEIC, Standard Chartered Research. As of June 2015.

For RMB to become an interesting global currency from a number of perspectives, the first
target should be for it to become a truly representative regional currency. The current prominent
Asia-Pacific regional currencies are South Korean won (KRW), Singapore dollar (SGD), Malaysian
ringgit (MYR), and with specific correlations: Japanese yen (JPY) and Australian dollar (AUD). The
nature of these currencies has developed over many years of free-float and sensitivity to domestic
and global-macro economic factors. KRW, SGD and MYR for example, will all show sensitivity to the
regional growth performance of Asia-Pacific. They are all three medium-sized open economies with
large regional trade sectors and strong ties to China. The AUD has a particularly pointed sensitivity to
Chinas commodity demand, while JPY is a regional reserve currency and defensive proxy during
times of both regional and global stress. The CNY, on the other hand, due to its limited history of
free-floating price action, has no particularly real economic or geographic characteristics evident in
its historical price series other than its quasi-pegged relationship to the US dollar (Graph 4). It is not
possible to declare what characteristics the CNY would exhibit in the next 12 months if tomorrow the
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Chinese Authorities elected to fully liberalize their capital account and float the RMB. Global market
participants understand Chinas economy, and they can analyse the market capitalization of Chinas
stock market in a traditional way, but the first 12 months of a RMB free-float would be fraught with
uncertainty. The capital flow implications of its large structural trade surplus would need to be
considered against what could potentially be a tsunami of pent up desire to export capital, repatriate
foreign profits, diversify domestic savings and seek international investment alternatives. This is the
kind of assessment that one makes of an emerging market currency opening to the world for the first
time, not a global reserve currency. The CNY needs a period of free float and minimal influence from
the Authorities to allow it to establish a natural relationship with domestic economic trends, current
account responses to currency valuation, relative competitiveness, and patterns of change in global
risk premium. On paper China has strong economic fundamentals, but until global markets trade
and invest in its currency through various cyclical scenarios, CNY is an uncertain proxy for global hard
currency accumulation.

Graph 4
CNY Real Effective Exchange Rate History

USD/CNY VS rest of USD/ASIA

Source: BIS, Bloomberg, ANZ Research.

Once China liberalizes its financial markets and assumes a prominent stakeholder position in
the open and integrated global financial system, the CNY will most certainly enhance the opportunity
set of hard currency investment. With JPY as the only Asian currency currently in the SDR basket and
also significantly represented in the COFER basket, the addition of CNY as a reserve currency has the
potential to add both diversification and a stronger Asian geographic footprint. However, at present,
the addition of CNY to a SDR basket would offer little to no diversification, given its heavily managed

history relative to US dollar (USD). Adding the CNY to the basket in 2016, using historical correlations
with other SDR currencies would essentially increase the correlation to USD, not reduce it, as is so
often claimed by Chinese Officials as merit for such a decision (Graph 5). The CNY valuation in a new
hypothetical basket would not come solely at the expense of USD, but distributed across EUR, JPY
and GBP as well, leading to increased basket concentration in USD and CNY components. The loss of
weight to EUR and JPY, the two most negatively correlated with the dollar, and replaced with CNY
would produce a more concentrated SDR basket with less liquidity. This is hardly an optimal
outcome for IMF Members that use SDRs.

In Graph 5 below, we show the simple exercise of allocating 10% to CNY by proportionately
reducing the other 4 currencies (Basket 1), and then doing the same for USD (Basket 2), and for JPY
(Basket 3). The difference between the hypothetical SDR basket with a 10% allocation to CNY is
identical to allocating 10% away from EUR, GBP and JPY to the USD (the blue and orange lines
perfectly overlap each other). While adding an additional 10% to JPY relative to USD, EUR and GBP
did produce a differentiated outcome (the green line).

Graph 5
SDR Basket VS SDR+CNY Basket Scenarios
9%

Rolling annualised volatility of basket

8%
7%
6%
5%

Basket 1

4%

Basket 2
Basket 3

3%
2%
1%
0%
2007

2010

Basket 1
Basket 2
Basket 3

USD
37.7%
47.7%
37.7%

2013

CNY
10%
0%
0%

EUR
33.7%
33.7%
33.7%

GBP
10.2%
10.2%
10.2%

JPY
8.5%
8.5%
18.5%

Source: Macro Currency Group, Bloomberg, IMF.

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Information on chart is hypothetical in nature and are shown for Illustrative, informational purposes only. There are no guarantees that
the hypothetical performance presented here will have a direct correlation to any future performance.

In the end, the existing 2011 IMF methodology to

qualify for entry into the SDR basket is the single best
criterion for China to focus on in order to make its currency
a successful and predictable store of value. This is because,
in reality, the SDR Valuation methodology is a validation

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Macro Currency Group

exercise, not a pro-forma test for potential outcome.

1, Wood Street

China is an anomaly for sure. It has qualified based on the

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so-called gateway criterion for nearly a decade, even

London

when netting out cross border trade between the Mainland

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and HK, Macao, Taiwan. However, this anomaly has been a

macrocurrencygroup@principal.com

conscious choice on the part of Chinese Authorities to

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circumvent the Global Financial System, to delay its WTO

commitments made at the time of entry to eventually open
its capital account, and to artificially prevent its currency
from appreciating while it racked up a massive current
account surplus during the last decade. This anomaly is easily rectified by policy change in Beijing, it
is not necessary for the IMF to engineer this change via accelerated SDR inclusion. If China were to
truly liberalise its financial sector and open the capital account, the IMF Staff and Exec Board would
have a simple exercise in validating its SDR inclusion in 2020, as it would be self-evident in the
straight forward and rational criteria used to determine freely usable. Furthermore, the very goals
and merits attributed to SDR entry could easily be realized in the market place by simply liberalizing
its capital account. The great irony in all of this is that China does not need SDR entry to achieve any
of its stated goals of currency internationalization. Global reserve managers, themselves included,
respond every day to basic free market incentives and perceptions of value. For example, increases
in holdings of AUD, CAD, SEK, KRW and MXN in global reserve portfolios were seen last decade, none
of which are remotely close to qualifying for SDR inclusion. Any country that offers a highly liquid,
high-grade sovereign security that foreign investors can access to store savings has the potential to
be an important reserve currency. Being a large trading nation certainly identifies a country as a
potential attractive destination for global savings, but it does not command any such behaviour. The
global reserve managers vote with their feet daily. The COFER basket is the result of freedom of
choice. The SDR basket is simply a rules-based synthetic that makes up an accounting unit for IMFprovided reserve assets. The IMF SDR is a proxy of reality, not a determinant of reality.

Appendix I
RMB as a growing Regional Currency

Source: CEIC; and IMF staff calculations

Export of Goods and Services

Exports of Goods and Services

1/ (5-year avg, % of total)

1/ (5 year avg, % of total)

Source: IMF, World Economic Outlook; IMF, Direction of Trade Statistics; Census and Statistics Department, Hong Kong SAR; and Fund
staff calculations.

Bibliography
http://www.bloomberg.com/news/articles/2015-09-30/china-reports-reserve-data-to-imf-for-firsttime-in-reform-push
http://www.imf.org/external/np/pp/eng/2015/071615.pdf
https://www.imf.org/external/country/CHN/rr/2015/0811.pdf
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