“Time is what we want most, but what, alas, we use worst…”
-William Penn (1)
If only Penn – founder of what is now modern-day Pennsylvania – were alive today. Considered one of the most thoughtful, forward-thinking minds to ever grace planet earth, his works and writings partially serve as inspiration for the United States Constitution (via the “Frame of Government of Pennsylvania”), as well as the European Union (via his proposals to establish a European Parliament).
Surely he would be able to appropriately contextualize and navigate the many globally-interconnected risks associated with international trade and finance. One such key risk is the eventual advent of the Chinese yuan as a global reserve currency.
Back to the Global Macro Grind…
Yesterday, the IMF proposed extending the current SDR basket by nine months until September 30, 2016. This decision to delay any changes to the current composition of the basket is the direct result of member states’ lobbying efforts to avoid changes in the basket at the end of the calendar year to ensure continued smooth functioning of SDR-related operations.
While such operations are not necessarily worthy of mention, what we did find interesting is the IMF’s decision to NOT delay its review process of the current composition of the basket, which occurs every five years (with November 2010 being the most recent iteration). With respect to China – which has been intensely lobbying the IMF for inclusion of late – this means China’s date with destiny is going to come sooner rather than later. In fact, the review process is well underway and the results of these efforts will be revealed by year-end per IMF officials.
What does that process entail? According to the criteria for SDR inclusion (last updated in 2000), China must prove that the yuan plays a central role in the global economy. Secondly, the yuan has to be deemed “freely usable”, which means it is both “widely used” to make payments in international transactions and “widely traded” in principle exchange markets. It’s important to highlight that “freely usable” does not equal “freely convertible”; in fact, a currency can be widely used and widely traded even though it is subject to capital account restrictions (and vice versa).
As of today, the Chinese yuan is the only currency not currently in the SDR basket that meets the first criterion. Specifically, China’s exports of goods and services over the trailing 5Y period account for 11% of the world total, besting current SDR members Japan and the U.K. by 600bps and 610bps, respectively, and lagging the U.S. and Eurozone by 360bps and 820bps, respectively. This means determining whether or not the CNY is a “freely usable” currency will be at heart of this year’s discussion – the conclusion of which will determine whether or not the Chinese yuan will be granted reserve currency status in 2015.
Is the Chinese yuan “freely usable” as determined by the myriad of criteria the IMF focuses on in making this determination? Fortuitously for investors, there is no right answer. Real money is made by betting on the improbable becoming probable.
With respect to the previous question, on one hand, the CNY pales in comparison to the USD, EUR, JPY and GBP in terms of being “widely used” and “widely traded”. On the other hand, the rate-of-change across each of the following metrics suggests the yuan’s importance as an international currency has dramatically increased since the last SDR review and that this increasing importance should be considered a sustainable development.
The data presented below is in terms of share of global totals:
- Official Foreign Currency Assets: CNY = 1.1% in 2014, up from 0.7% in 2013. This compares to 63.7%, 21%, 4.1% and 3.4%, respectively, for the USD, EUR, GBP and JPY in 2014.
- International Banking Liabilities: CNY = 1.9% to 4.0% (depending on classification) in 2014. This compares to 52.1%, 29.7%, 5.4% and 2.8%, respectively, for the USD, EUR, GBP and JPY in 2014.
- International Debt Securities Outstanding: CNY = 0.6% in 1Q15, up from 0.1% in 1Q10. This compares to 43.1%, 38.5%, 9.6% and 2.0%, respectively, for the USD, EUR, GBP and JPY in 2014.
- Issuance of International Debt Securities: CNY = 1.4% in 2014, up from 0.1% in 2010. This compares to 42.1%, 37.1%, 11.6% and 1.8%, respectively, for the USD, EUR, GBP and JPY in 2014.
- Cross-Border Settlement: CNY = 1.0% in the four quarters ended 1Q15, up from 0.2% in the four quarters ended 1Q13. This compares to 41.6%, 36.6%, 4.3% and 3.3%, respectively, for the USD, EUR, GBP and JPY in the four quarters ended 1Q15.
- Trade Finance (Letters of Credit): CNY = 3.9% in the four quarters ended 1Q15, up from 1.9% in the four quarters ended 1Q13. This compares to 85.6%, 7.2%, 0.2% and 1.9%, respectively, for the USD, EUR, GBP and JPY in the four quarters ended 1Q15.
- Foreign Exchange Market Turnover: CNY = 1.1% in 2013 (the latest available annual data), up from 0.4% in 2010. This compares to 43.5%, 16.7%, 5.9% and 11.5%, respectively, for the USD, EUR, GBP and JPY in 2014.
This we do know: the burning desire for reserve currency status among Chinese authorities has perpetuated a dramatic increase in both the speed and scope of capital account and capital markets reform in China, including:
- Increasing the participation of foreign central banks and institutional investors in Chinese capital markets;
- Granting foreign entities greater freedom to issue yuan-denominated debt and/or raise equity capital in China;
- Granting domestic entities greater freedom to issue foreign currency-denominated debt and/or raise equity capital abroad;
- Further promoting the use of the yuan for international trade and settlement; and
- Liberalizing interest rates.
With respect to the aforementioned reforms:
- As of May, the PBoC has allowed 152 foreign institutional investors access to China’s $6.1T interbank bond market (far and away its largest and most critical), an increase of 34 entities in the YTD.
- As of 2Q14, foreign entities held a mere 1.9% of China’s general government gross debt securities, which is far and away the lowest share of foreign participation among the 24 emerging market economies tracked by the IMF and compares to a sample average of 35.3%. This compares to an even lowlier 1.1% of foreign participation in mainland equities.
- The current 870B yuan quota for China’s Renminbi Qualified Foreign Institutional Investor program (RQFII) – which allows international investors to purchase Chinese stocks and bonds with yuan raised offshore – accounts for a mere 2.9% of China’s general government gross debt outstanding and 2.1% of mainland equity market cap.
- Chinese individuals can only move a maximum of $50,000 per year out of the country, effectively limiting their investment options to cash, CNY bank deposits, domestic debt and equity securities, property and physical gold. Moreover, China’s stock of narrow and broad money is extremely significant as a share of world totals at 19.8% and 24.9%, respectively. For companies, overseas securities investment is currently capped at $300 million.
- The proportion of China’s trade that was settled in yuan has risen from 0.02% in 2009 to nearly 25% in 2014. Moreover, there are now 15 offshore clearing centers for the yuan around the world. Additionally, over 20 foreign central banks have signed currency swap agreements with the PBoC totaling about $430B.
- A key hurdle for interest rate liberalization in China was surmounted in May when the PBoC introduced a deposit insurance program that will fully cover deposits up to 500,000 CNY. This effectively shields Chinese households, on the margin, from any fallout resulting from increased competition for deposits that would naturally occur as a function of removing the deposit rate ceiling and follows efforts in 2013 to meaningfully lower the floor for lending rates. China currently has $19.7T in bank deposits.
In short, there are two primary reasons Chinese officials are so desperately seeking reserve currency status for the yuan:
- International portfolio rebalancing among institutional investors is likely to be overwhelmingly unidirectional. Specifically, the preponderance of capital will likely flow to China in lieu of other lower-yielding reserve currencies, at the margins. We discuss these dynamics in greater detail on slide 72 of our recent presentation titled, “Is Consensus Right On China?”. Such asset allocation adjustments will help offset the recent dramatic acceleration of capital outflows (read: the reversal of “hot money” flows) from the mainland, which accelerated to a record TTM sum of $510B as of June. Refer to slides 35-38 of the aforementioned presentation for more details.
- It would help China secure another major victory in its ongoing battle versus the U.S. for economic and political clout. Investors, politicians and businesspeople the world over who “know China” understand very well that Chinese officials are displeased with the current state of global affairs where the U.S. is the primary hegemonic power. Achieving reserve currency status would be the latest triumph in an increasingly impressive list of “wins” in the YTD, including securing support from key U.S. allies for the Beijing-led Asian Infrastructure Investment Bank (AIIB), as well as for the very topic we are discussing – reserve currency status. In fact, in spite of the recent spate of heavy-handed policy intervention in mainland equity markets, the IMF recently affirmed its support for the yuan’s inclusion into the SDR basket; it’s merely a matter of when, not if. Additionally, the IMF has taken an opposing stance to the U.S. Department of the Treasury by recently deeming the yuan to no longer be “undervalued”.
All told, we can’t stress enough how impactful China’s capital account reform measures will be to the global economy. While the reform drive will no doubt continue to be piecemeal and full of incremental quotas (Chinese officials credit the country’s closed capital account with shielding the mainland economy from the 1997-98 Asian Financial Crisis and the 2008-09 Global Financial Crisis), meaningful progress will be achieved sooner than many investors may assume.
Whether it happens in 2015 or 2020 (the U.S.’s vote could make or break China’s bid), achieving reserve currency status for the yuan is not the end game. Rather, it’s simply the beginning of a long-lasting series of tectonic shifts in and across the global economy and the financial markets that underpin it.
Is your portfolio appropriately positioned for these changes?
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.16-2.29% (bearish)
SPX 2068-2119 (bearish)
VIX 11.88-15.24 (bullish)
USD 97.04-98.44 (bullish)
EUR/USD 1.08-1.10 (bearish)
YEN 123.34-124.99 (bearish)
Oil (WTI) 44.36-47.12 (bearish)
Gold 1075-1101 (bearish)
Keep your head on a swivel,