China share in global indices set to rise

Come June, the International Monetary Fund will probably decide to include the Chinese renminbi in its special drawing rights (SDR).

Though the move is largely symbolic, the symbolism is huge. It is yet another acknowledgment of China's growing stature in the global economy and in financial markets. It is also a marker underscoring how swiftly China is moving to dismantle capital controls, in line with the reform policies of the People's Bank of China.

That in turn has implications for investors. It will mean China could soon assume an even larger weight in crucial global financial markets.

For example, today, China is a mere 2.5 per cent of the MSCI All Country World Index, based on Chinese companies listed in Hong Kong. But, when the powers that be decide the currency is convertible enough, onshore Chinese shares could be included in the index, which means its share of the index could rise to more than 10 per cent, according to Michael Cembalest of JPMorgan Asset Management.

Today, the renminbi is most visible as the currency in which a growing portion of Chinese trade is denominated. Chinese companies often offer more attractive prices and financing to counterparts that will trade in renminbi, thereby eliminating their own foreign exchange risk.

More importantly, the renminbi is also growing in stature as an investable currency. Today, Mr Cembalest adds, central banks and sovereign wealth funds have invested between Rmb300bn and Rmb400bn in renminbi-denominated assets. While most of these are in Asia, the European Central Bank has also said it is considering investing in such assets.

Moreover, Japanese central bankers say they are considering agreements whereby the Bank of Japan and the PBoC would expand investing in each other's government bond markets (assuming the upcoming anniversary of the end of World War Two does not lead to a new outbreak of hostilities between the two countries). The two central banks are also considering resuming swap lines. China already has almost Rmb10tn of such arrangements with 30 central banks.

Meanwhile, China's young asset management groups and securities firms are designing ever more products in local currency both onshore and offshore, where Rmb2tn in deposits sits, most of them in Hong Kong.

China does not have to remove all controls on its currency, particularly rules on portfolio investment flows, for it to qualify for inclusion in the IMF basket. Even today, only four items out of 40, or less than 15 per cent of the capital account, have restrictions, according to Qu Hongbin, chief China economist for HSBC in Hong Kong. After all, even Singapore and Hong Kong retain some constraints on their currencies.

The Chinese government's willingness to remove restrictions on the renminbi comes in the face of widespread fears, especially outside China, of slowing economic growth on the mainland and of a possible debt crisis, given the fact that debt in China has grown by 70 per cent since the global financial crisis in 2008.

The combination of offshore flows from various conglomerates and diminishing returns on domestic investment suggests that as China lifts controls, at least over a short period of time, the renminbi will lose value. After all, in the past three quarters, there has been about $333bn in outflows of hot money from China, (much of them from companies hedging or repaying their dollar debt). Moreover, reserves, which ended the year at $3.8tn, declined to $3.73tn at the end of the first quarter.

So far, the renminbi has been one of the few currencies to actually hold its value against the dollar in a world of increasing competitive devaluations. China has recently started to ease monetary policy, but it is trying to do so in a far more measured way than either Japan or Europe. A one-time competitive devaluation to support exports is less attractive to the Chinese than the gradual appreciation that makes its currency attractive as a store of value.

The growing legitimacy of the renminbi also comes at a time when the rest of the world is searching for a credible alternative to the dollar as the only real reserve currency.

Cliff Tan, an economist with MUFG, jokes that the acronym SDR should stand for "some day renminbi". That "some day" is fast approaching.

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