CNH: billion dollar baby

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1 Interest rate strategy CNH: billion dollar baby DBS Group Research 16 November 215 The IMF is likely to include the CNY into the SDR on 3 Nov. If so, the new SDR will be operational by 1 Oct 216 In the short-term, the decision is symbolic with limited impact on financial markets China is aware that SDR membership is neither a necessary nor sufficient condition to accept the CNY as a global reserve asset China is expected to press forward with more reforms and build upon the steps it has taken over the past five years to put the CNY on the world stage The International Monetary Fund (IMF) staff issued, on 13 Nov, a report to the Executive Board on the Special Drawing Rights (SDR) quinquennial review. The Chinese yuan (CNY) has reportedly met the fund s two main criteria widely used and freely usable for inclusion. The Chinese authorities also addressed all operational issues identified in an initial staff analysis submitted to the Board in July. IMF Managing Director Christine Lagarde supports the staff s findings. She will chair a meeting of the Executive Board to formally consider the issue on 3 Nov. If successful, the CNY will formally become a part of the SDR with effect from 1 Oct 216. Overall, the inclusion of the CNY into the SDR should not come as a surprise. We were among the first who believed that this will happen (CNH: To break fresh ground in 215, 17 Nov 214). Inclusion of yuan in the SDR makes the basket more representative of the structure of world trade and finance A more diversified and representable SDR Adding the CNY would make the SDR a more representative reserve currency that better reflects the growing contribution of emerging markets to world trade and finance. This could lead the SDR to become a more meaningful substitute reserve asset, and encourage the SDR to be more actively traded with higher volumes. As of Sep 215, only about USD 28bn in SDRs were allocated to IMF member countries. This represented a mere 2.5% share of global reserves (USD 11.3trn), a share that has fallen sharply from its 8.4% peak in the early 197s. The willingness of central banks to participate in the SDR is influenced by other factors. One of them is China s exchange rate regime. To incentivize IMF member countries to consider using the SDR as a reserve asset and as a unit of account, the SDR basket has to be more stable against their currencies. To achieve this, the CNY needs to reduce its high correlation with the US dollar by floating more freely. Nathan Chow (852) nathanchow@dbs.com 1

2 The yuan will comprise 3% of global reserves (USD 34 bn) by end-216 Limited market impact We estimate the CNY to make up 1% of the SDR basket or USD 28bn of direct SDR allocation. Between now and 1 Oct 216, central banks would need to buy an average USD 2.8bn worth of CNY every month. This amount is negligible when compared to the USD 2bn daily transaction volumes in the onshore spot market and the USD 6.4trn worth of outstanding bonds denominated in CNY. The corresponding reduction in the shares of other SDR currencies (USD, EUR, GBP and JPY) is also inconsequential. Hence, the CNY s inclusion in the SDR has a limited impact on financial markets. To be certain, the IMF s stamp of approval will encourage further reserve accumulation (beyond SDR allocation). While information on the actual reserves held in CNY is not available for the time being, we project that the CNY will comprise 3% of global reserves by the end of 216, ahead of the Canadian dollar and the Australian dollar (~2% each). This implies that only USD 34bn out of the USD 11.3trn in global reserves could be allocated into CNY-denominated assets by end-216. Hence, there is no material impact on the roles of the USD and the EUR as settlement and invoicing currencies in international trade. This could, however, change in the longer term should the CNY keep increasing its weight in the SDR. As the CNY emerges as a major reserve currency, it could erode the privileges that the US enjoys from owning the world s top reserve currency. Essentially, America currently issues all of its debt in its own currency at a lower cost. Substantial purchases of US Treasury securities by foreign governments and agencies have reduced the US borrowing rate by 5-6 basis points and led to yearly savings of USD 9bn 1. For emerging markets, this has led to currency mismatches that triggered crisis in the past. In this regard, CNY could be more stable for emerging markets. Between symbolism and substance While SDR membership is symbolically important, it is neither a necessary nor sufficient condition for accepting the CNY as a global reserve asset. For example, when EUR was launched in 1999, many believed that the single currency would rival the USD as a global reserve asset. EUR s share of reported global reserves rose to around 25%, stalled and fell back to below 2% (Chart 1). The Eurozone crisis was an important lesson that fundamentals mattered. The loss in confidence over the EUR led to fragmentation. Essentially, liquidity fled from EU countries that badly managed the sovereign debt crisis to better-managed assets that are liquid and safe such as Bunds. Chart 1: Currency composition of official foreign exchange reserves 8% 7% 6% 5% 4% 3% 2% 1% % Q2 US dollar Euro Pound sterling Japanese yen Canadian dollar Austrlian dollar Swiss franc Other 2

3 Beijing will speed up the pace of market reforms and liberalisation It is not practical for yuan to become a reserve currency if foreigners holdings account for only 2% of domestic bond outstanding Clearly, deep and liquid markets matter to reserves managers. After all, reserve assets are held for liquidity management purposes. In light of this, Beijing will speed up the pace of market reforms and liberalisation, in particular, the onshore bond market. Notwithstanding its hefty size, China s bond market merely equates to ~5% of the country s GDP. This is low compared to the average 2% for key developed markets. Liquidity is another issue that must be addressed. The annual turnover rate for China s government bond (CGB) is only.54x; below the regional average of.67x (Chart 2). It is also impractical for. the CNY to become a reserve currency if foreigners CN HK ID JP KR MY SG TH holdings accounted for only ~2% of outstanding domestic bonds. This is low compared to ratios in other markets such as Australia (65%), the US (5%), and Russia (25%) (Chart 3). Hence, the CNY s growth as a reserve currency will require China to further increase access to its domestic markets. Encouragingly, the mainland authorities have, over the past year, been loosening restrictions on bond market access for both overseas official and private institutions. Equally impressive was the growing issuance of financial/corporate/ municipal bonds, which offer more diversity to the usual staple of government and policy bank bonds. Major strides were also made on exchange rate liberalisation. The introduction of a new and more market-determined exchange regime should allow the PBoC to step back further from dayto-day intervention over time. More importantly, it helped to close the spread between the central parity and the spot exchange rate, an important criterion for the CNY to enter the SDR. Chart 2: Government bonds turnover ratio Chart 3: Foreign holdings of domestic government bonds % avg..67 As per the official report released after the 5th Plenum, China will opt for a negative list foreign-exchange system during the 13th Five Year Plan (216-22) with a target to achieve full convertibility of the CNY by 22 (for potential impacts, please refer to our Asian Insights report Understanding Capital Account Liberalisation: Risks and Rewards ). This will greatly enhance the hedging ability for reserve managers. 3

4 The yuan now is just a baby on the global stage. But so was the dollar at the start of the 2th century A new checkpoint in an exciting journey The CNY s entry into the SDR should not be viewed as an end point to its internationalization. Instead, this should be seen as another key milestone in its exciting journey to become a global currency. Over the past five years, the baby steps taken by China have led the CNY to leap forward on the world stage. For example, the share of cross-border trades settled in CNY increased from virtually zero in 29 to 3% in 215 (Chart 4). Ranked 2th by SWIFT in 212, the CNY is now the 5th most used currency for payments as at Oct 215. The CNY is also number one for Asia Pacific intraregional payments with China and Hong Kong. As for trade finance, the CNY is ranked 2nd for global issuance of letters of credit by value. Some 6 central banks have invested reserves in CNY. Despite these achievements, the CNY is still far from rivaling the USD. To most, the CNY, by comparison, is just a baby on the global stage. Then again, so was the USD whose rise to the prominence in the 2th century came gradually instead of a single leap. Chart 4: Yuan cross-border trade settlement RMB bn Trade volume % of China's total trade (rhs) % Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Footnote 1: Dollar as reserve currency: Mixed signals, McKinsey Global Institute 4

5 Recent Research EZ: will more QE help? 4 Nov 15 Rates: regional rates rundown 2 Nov 15 FX: monetary policy divergences intact 2 Nov 15 Rates: UST Curve - the next flattening leg 3 Oct 15 JP: deciphering the BOJ 23 Oct 15 ID: no room to cut 12 Oct 15 IN: the lowdown in exports 9 Oct 15 SG: technical recession 6 Oct 15 SGD: a lower policy band 6 Oct 15 CN: resolving the known unknowns 5 Oct 15 G4: who s winning the currency wars? 25 Sep 15 IN: RBI another window opens 22 Sep 15 Japan s go global experience (3) 21 Sep 15 SG: mandate for inclusive policy 17 Sep 15 Qtrly: Economics-Markets-Strategy 4Q15 1 Sep 15 Triangulating Asian Angst: the US, China 7 Sep 15 and the 97 question CN: the need for institutional reform 21 Aug 15 SG: when China devalues 2 Aug 15 TW: the impact of yuan devaluation 19 Aug 15 IN: harnessing demographic dividend 27 Jul 15 CN: fiscal reforms to accelerate (2) 24 Jul 15 SG: slowest growth in six years 9 Jul 15 CN Rates: stock market woes driving 9 Jul 15 onshore/offshore divergence Greece: near the tipping point 6 Jul 15 ID: investors staying put 6 Jul 15 VN: Asia s latest electronics spark 1 Jul 15 Japan s go global experience: implications for 3 Jun 15 China SG: watch core inflation 16 Jun 15 Qtrly: Economics-Markets-Strategy 3Q15 11 Jun 15 IN: weak monsoon a risk 8 Jun 15 CN: the AIIB to test diplomatic skills 4 Jun 15 Rates: the rise in global yields where to now? 25 May 15 TH: still climbing Sisyphus Hill 22 May 15 IN: time to deliver 21 May 15 KR: what will the AIIB mean for Korea? 19 May 15 Asia: breaking new new ground 11 May 15 CNH: Q expansion heralds next stage of 6 May 15 capital account liberalization SG: saving manufacturing 17 Aug 15 IN: inflation remains key 6 Aug 15 Greece: the clock is ticking MY: limited options 4 May15 29 Apr15 IN Gilts: greater foreign ownership mooted 4 Aug 15 IDgov bonds: 2Y sector looks attractive 31 Jul 15 JP: Japan s go global experience (2) 29 Jul 15 India and Indonesia: taking stock 29 Apr 15 US: over the hump (and sliding fast) 28 Apr 15 Asia bonds: floating on a yield cushion 27 Apr 15 Disclaimer: The information herein is published by DBS Bank Ltd (the Company ). It is based on information obtained from sources believed to be reliable, but the Company does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee. The information herein is published for the information of addressees only and is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Company, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Company or any other person has been advised of the possibility thereof. The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Company and its associates, their directors, officers and/or employees may have positions or other interests in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking and other banking or financial services for these companies. The information herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. 5