FSG believes that the Chinese yuan’s inclusion into the IMF’s SDR basket will not lead to drastic changes in the international financial system in 2016; however, it’s critical for multinationals to have a holistic view on the value of the currency in the short-term and how this can impact contracts with Chinese distributors and customers for an effective P&L management. Our analysis below provides inputs on: (a) Impact of the Chinese yuan’s SDR inclusion (b) FSG’s renminbi base case view for 2016 (c) Implications for multinational businesses.
Impact of the renminbi’s SDR inclusion
The Chinese yuan has achieved a symbolic milestone, but the SDR inclusion is unlikely to cause fundamental changes in 2016 on China’s market liberalization or the global financial system
In November 2015, the International Monetary Fund officially included the Chinese renminbi in its Special Drawing Rights basket, along with the U.S. dollar, euro, Japanese yen and pound sterling, effective Oct. 1 of 2016. While the SDR status will provide central banks and other global institutional investors with more confidence to hold the yuan in the future, the privilege of having been selected as one of the IMF’s global reserve assets is unlikely to offer the Chinese yuan significant benefits or lead to drastic foreign exchange market changes in 2016.
- The yuan’s weighting in the global reserves is yet very small
The direct impact of joining the IMF’s global reserve basket will be minimal for China. Given the SDR’s minor share of total global reserves, the renminbi’s 10.92 percent portion in the SDR basket is insignificant to cause fundamental market shifts. Ongoing efforts are still needed from the People’s Bank of China (PBOC) to further internationalize the renminbi before it could increase prominence in the global financial system.
- Financial liberalization is a multi-year goal, but unlikely a 2016 reality
The renminbi’s enhanced exposure to global finance as an international reserve currency will push the Chinese government to deepen its reforms in exchange rate and capital control to make the currency more freely tradable. However, while financial market liberalization, more specifically opening the country’s capital account, is China’s long-term goal by 2020 in the 13th Five-Year Plan, the government is more likely to adopt gradual reforms in 2016 to avoid market shocks, such as the surprising devaluation this August.
FSG’s base case view for the renminbi in 2016
Drastic devaluation of the yuan’s value is unlikely
The Chinese government will continue to seek a balance between a longer-term economic transition and short-term headline GDP growth. To maintain this balance, the government is likely to prioritize a relatively stable yuan over currency liberalization.
Several practical points support this view:
- Internationalization is a slow process. A stable currency in the medium term will support international usage of the yuan, and the government is unlikely to rush the process by destabilizing the currency all at once.
- The PBOC holds enough foreign exchange reserves to maintain a stable currency. Even amid trade weakness, China’s large trade surplus continues to contribute to a resilient foreign exchange reserve of $3.53 trillion. August’s devaluation was costly, at about $93.93 billion, but at only 2.6 percent of total reserves, the government has substantial support in its arsenal to maintain a stable currency.
- Capital flight is a real threat. Expectations of tighter monetary policy from the Federal Reserve has prompted capital flight from emerging markets globally in 2015. China has supported yuan’s value, but the currency would likely experience depreciation if that support were to wane. The Chinese government will continue to seek to avoid financial market panic and increase investor confidence, making rapid liberalization less likely.
- The impact of currency devaluation on supporting China’s export sector is diminishing. As China shifts from an investment-led economy to a consumption-led growth model, exports have been slow to revive the economy. The impact of a 3 percent yuan devaluation in August on exports was minimal with the relative depreciation of many other global currencies, thus it is unlikely that the government would rely heavily on currency as a means to growth under weak global demand.
However, global monetary conditions could result in moderate devaluation against the USD in 2016
While currency stabilization remains China’s policy goal, the Fed’s potential interest rate hike will impose heightened pressure on the PBOC in keeping up with the USD rising value. The PBOC is thus likely to adopt some moderate devaluation against the dollar in 2016, leaving its value high relative to other global currencies. FSG expects the USD: CNY exchange rate to rise to around 6.50 by the end of 2015, and the average-of-period exchange rate in 2016 to be around 6.60.
Implications for multinational businesses
- Capitalize on the wider use of the renminbi in trade settlements
Not only does the wider use of the Chinese renminbi help multinationals in China lower transaction costs, it also supports forming better relationships with Chinese trade partners. Multinational companies are encouraged to establish more treasury functions in China to obtain greater visibility, control and flexibility over onshore and offshore renminbi-denominated cash flows.
- Seek opportunities in RMB-denominated investments
With rapidly growing offshore RMB-denominated bonds in HK and the recently established market in London, multinationals can expect the renminbi to become a more convenient investment tool over time.
- Evaluate Chinese customers and distributors on foreign-currency debt levels
As the U.S. dollar is likely to grow stronger in 2016, it will become more difficult for local governments and developers to pay back dollar-denominated debts given the moderate devaluation of yuan against USD in 2016. With tightening credit for many local companies, multinationals also need to keep more frequent conversations with key customers and distributors in China on their financial health.
- Closely monitor China’s economic health and monetary policy
It will be critical for multinational companies to track key leading indicators for their respective industries and China’s overall economic and financial health, as well as to conduct contingency planning for expected currency volatility.