Friday, 4 December 2015

Why China’s plan to internationalise renminbi could 'spook' markets further

The decision by Chinese policymakers to challenge its currency last month rattled markets significantly, with the devaluation of the renminbi in mid-August seen by many as a catalyst for the global sell-off in equities last month. The sell-off saw the FTSE 100 fall 4.7% alone on ‘Black Monday’, shedding some £96bn, and the Shanghai Composite was down 8.5%, wiping out all the gains it had made in 2015 so far.But there is a fear further changes to the currency could be on the cards, especially as China looks for the renminbi to be included in the IMF’s Special Drawing Rights. This is likely to spook global markets further. China’s latest currency decisions have indeed been, at least in part, a bid to internationalise its currency. For three days in a row last month, the PBoC devalued the renminbi in its daily fixing against the US dollar by 1.8% on 11 August, 1.6%, on 12 August, and 1.1% on 13 August – a total of 4.5% in three days .
The devaluation move stoked a sell-off in the currency in both the onshore and offshore markets. By the middle of the second day, the onshore market had fallen by 4% while the offshore market (CNH) had fallen by 6%, before the PBoC reportedly intervened to pull back the markets.Market participants who initially saw the PBoC’s announcement as a liberalisation move rather than one of devaluation were subsequently convinced there was some degree of the latter intended by policymakers. But, in our view, the two objectives hold equal weight – the need to switch to a free market mechanism and second, the need to revive growth. IMF endorsement : China has long made known its desire to have the renminbi included in the International Monetary Funds’ Special Drawing Rights (SDR). Likewise, the IMF has been increasingly clear it would support China’s bid for SDR inclusion to the extent that the organisation recently said the criterion of “free usability” does not require the SDR component currency to be fully convertible. However, there was a question about the Chinese currency’s official exchange rate, being a true market rate given the actual spot market was trading nowhere close to it. Hence, it was inevitable that the PBoC had to ‘fix its fixing’. It also seems clear that the move was implicitly sanctioned by the IMF, as evidenced by a statement the day after to say it welcomes the PBoC’s move and that the consequent devaluation of the renminbi would not impact the SDR decision.The IMF also stated earlier in the summer that its decision on China’s SDR inclusion could be delayed to September 2016. The delay, we believe, is to give China more time to promote the renminbi to other central banks to hold the currency in their reserves. The SDR weight is calculated as an average of the renminbi‘s use in international trade and representation in world reserves. Without much of the second, the renminbi‘s weight would come well below 10% and China would be stuck with a low SDR weight for five years . By delaying the decision by a year, there is good chance for China to achieve 15% to 20% in the SDR, given that it already scores very highly on the first factor.As China gains more success in promoting the renminbi to other foreign central banks, the mere substitution of US dollar for renminbi would act as a stop to the freefall of the currency. Once included into the SDR, the renminbi will also gain seigniorage value as a reserve currency. In this regard, we only have to extrapolate the Japanese yen’s pace of appreciation over the two decades after its inclusion into the SDR in 1980 to gauge where dollar/yuan could be heading on a very long-term horizon. So while we believe renminbi weakness will persist for a few months until at least the Fed’s first rate hike, we do not expect the currency to devalue more than 10% versus the dollar, and we maintain our confidence that the currency will be included into the IMF SDR basket in a year from now. Thereafter, the currency will likely find itself on a long-term appreciation path.

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