Wealthy Nations Daily Update - China SDR

The article in yesterday’s FT was a good assessment of where China stands in its campaign to achieve reserve currency status for the renminbi (RMB). Of particular note is that the US has given conditional support for inclusion of the RMB in the SDR basket, with the conditions merely being that the currency meets the technical requirements.

The article correctly states that the essence of the technical issues is whether central banks around the world can get access to RMB in a timely and relatively costless manner. In simple terms, the point of the Special Drawing Rights (SDR) basket is for central banks to be able to access 'hard' currencies in times of stress. Think of emerging countries that need to have ready access to US dollars, or another of the hard currencies, so domestic companies can pay their debts. The SDR serves the same purpose, except that it is broader and includes currencies, namely the US dollar, Japanese yen, euro and sterling, which are freely exchangeable amongst themselves at minimal cost.

Here is where the Chinese still have work to do. Foreign central banks need liquid instruments denominated in RMB to hold in their reserves and China's debt markets are underdeveloped and not widely held outside of China. Until recently, neither local interest rates nor the currency were 'market-based' in the sense of deep and liquid markets. To make their debt markets more widely held, China must include foreign investors in the mix and this is where reforms of the capital account are ongoing in the quest for SDR status.

Opening the capital account or having a completely floating exchange rate is not conditional per se for SDR status. Rather, the IMF must merely be satisfied that central banks have ready access to RMB in times of stress. So the technical hurdles remain mostly related to the functioning of and access to the domestic debt markets, which we have argued is an ongoing policy move that the Chinese are gradually putting in place.

The bottom line of the FT article is that SDR status is moving forward and is increasingly likely with US acquiescence, which is good news for stability in the RMB and for calming capital flight, as we have seen. However, the headlong rush to liberalise China's managed financial system has caused problems with valuation and the opening of China's debt markets is likely to bring glitches as the opening up of markets usually does.

Chinese sovereign and quasi-government debt markets offer the greatest opportunity; where issuance is backed by the wealth of the Chinese sovereign balance sheet.