SDR entry an untimely trophy for Beijing

HONG KONG - Will China benefit from inclusion in the SDR basket alongside the U.S. dollar, the euro, the British pound and the Japanese yen? Global asset manager Nataxis says it would have been much better for China to consolidate domestic and external financial reform before becoming an SDR currency.

“Given the public support expressed by Christine Lagarde, the IMF's managing director, and the backing of key member countries such as the UK and France, Chinese participation in the SDR regime is now almost certain to be agreed when the fund's executive board meets (on Monday),”Nataxis says.

If the Chinese yuan becomes part of the SDR basket, two potentially different scenarios will emerge, Nataxis says.

“The first is one in which Chinese authorities follow through with the necessary requirements for the yuan to become a true reserve currency, which would require a fully open current account and a decision to allow the currency to fluctuate freely, like the other four currencies in the SDR basket.

“The second scenario is one in which the yuan becomes a "stable" reserve currency whose value is heavily influenced by central bank intervention and capital controls. This would be against the spirit of the agreement likely to be reached with the IMF, although everybody involved -- including the IMF board -- knows that it is the most likely scenario.

“These scenarios have different macroeconomic implications for China. The first would imply much larger gross capital flows into and out of China, massively increasing exchange rate volatility.
“It seems fair to say that China's financial markets are not yet ready for a flexible exchange rate.
Hedging opportunities are limited, and Chinese banks find themselves saddled with the consequences of two massive credit binges, the first in the form of lending to local governments and the second from lending to Chinese corporations with fragile balance sheets.

“On top of all this, the economy is slowing. This is not a good time to risk heightened currency volatility.
 
“If China opts for the second scenario, it seems hard to believe that global investors will really increase the share of yuan assets in their portfolios since the onshore market will remain relatively closed and the currency will continue to be subject to heavy official intervention.”
 
Nataxis says there is no doubt that many central banks will switch parts of their reserves into yuan as it becomes part of the SDR basket,” but this will amount to nothing but a mechanical rebalancing affecting less than than 0.3% of global reserves”.

“This is because SDR reserves amount to just about 2.3% of total global reserves, and China is expected to be given a share of about 13% of the SDR basket.

“Even a mechanical rebalancing on this small scale would create temporary additional demand for the yuan, raising upward pressure on the currency, which is already overvalued. However, more widespread use as a reserve currency is unlikely to follow.

“Being recognised on paper as a reserve currency will have little impact in the real world if market forces are not allowed to operate.” www.nataxis.com (ATI).