Multilateral institutions set to recalibrate their currency holdings

The announcement that the renminbi meets the International Monetary Fund’s criteria as a “freely usable” currency will have come as no surprise to those who have followed China’s unprecedented steps to open up its capital markets.

It means a technical hurdle on the renminbi’s ascent as a global currency has been cleared away and makes it near certain that the IMF executive board will include the Chinese currency into its Special Drawing Rights (SDR) basket of currencies, effective from October 1 next year.

A monumental milestone for the renminbi, this event would trigger significant but gradual inflows of funds into the currency, changing the global currency landscape forever, as central banks, sovereign wealth funds (SWFs) and multilateral institutions recalibrate their balance sheets.

Many will not wait until next year before taking action. Indeed as many as 70 central banks have already invested part of their reserves into renminbi, either inside China or offshore.

The reforms made by China to qualify for SDR inclusion have been so radical that — to public sector investors — the renminbi has become fully convertible with no restrictions on access or size of investment in the China interbank bond market, something that has gone largely unnoticed.

Six out of the world’s 10 largest central banks have so far refrained from investing in the Chinese interbank bond market. However, because of China’s recent reforms, these and many other public sector investors are now reviewing their stance.

Eventually, we should expect to see the renminbi reach a double-digit share of global reserves — inflows in the order of $800bn to more than $1tn. Even a conservative estimate of a reallocation of about 1 per cent of global reserves each year would mean about $80bn inflows annually — no mean sum.

Added to the moves by central banks, will be those by SWFs. Norway’s SWF alone is likely to invest over $40bn according to their GDP weighted benchmark.

The implementation of the renminbi’s inclusion in the SDR basket 10 months from now is also set to inevitably trigger a significant rebalancing or hedging demand for the Chinese currency, though this, too, is likely to occur gradually.

Contrary to common perceptions — given that the aggregate SDR assets of the central banks in the IMF member states (around $280bn) have an equal amount of SDR liabilities — the renminbi’s addition to the SDR basket would not actually trigger a system-wide hedging demand, though some countries that are long or short on SDR may hedge their positions.

This event will change the global currency landscape forever

Instead, by far the most significant direct effect from the RMB’s inclusion on currency flows would come from multilateral institutions. The IMF’s own investment account and investment by its Poverty Reduction and Growth Trust would need to be rebalanced to include the renminbi.

Likewise, institutions such as the Bank of International Settlements, the African Development Bank, the Islamic Development Bank, the Arab Monetary Fund and the International Fund for Agricultural Development have SDR-denominated balance sheets, which would need to be rebalanced.

The World Bank and Asian Development Bank would also be affected as some of their facilities for the world’s poorest countries are denominated in SDR. The combined size of these multilateral institutions’ SDR denominated balance sheets is around $600bn, so the resulting renminbi flows could be more than $80bn assuming existing SDR weighting methodology.

The renminbi’s weight in the SDR basket has been the only big issue left for the IMF executive board to decide. Recent suggestions by some stakeholders that using existing methodology could leave the renminbi with too big a share of the basket (at around 14 per cent, far greater than that of the pound and the yen) will hopefully have been ignored the Board.

While the current weighting formula may not be ideal, the renminbi and the markets are fully ready to handle the direct implications of the SDR inclusion with the existing weighting methodology.

The writer is managing director and head of central banks and sovereign wealth funds at Standard Chartered Bank. He previously worked for the IMF and the central banks of New Zealand and Finland.