China and the SDR: history repeats itself
So, China joined the SDR. Not a big suprise… as we already explained in this post, one of the reasons behind the devaluation of the yuan some monthes ago was to give Christine Lagarde and the IMF an excuse to include the chinese currency in the SDR basket.
To summarize, the SDR is a reserve asset created by the IMF to supplement countries’ foreign exchange reserves and offer liquidity assistance when needed. The value of a SDR is defined by a basket of currencies, including the US dollar, Euro, Japanese Yen, British Pound and, now the Chinese Yuan, which will weight a 10% in the basket.
Although it does not fully meet the conditions to be included in the SDR, China has been pressing a lot, and the IMF has made an exception and included it anyway. Why? And why is China so interested in adding its currency to the SDR basket?
Chinese finances are in a similar condition today as Chinese trading was in 2001 when China was allowed to join the World Trade Organisation. Back then, trading was heavily controlled by the government, China did not meet all the criteria to be allowed to join, but an exception was made. China was very interested in joining because it needed to convince foreign investors that they could invest in China, as they needed foreign investment to grow. And western institutions thought that allowing China to join, they would force it to accelerate reforms to make trade less controlled by the government. Look at the result, 15 years later, and both parties got what they wanted.
Today, the situation is the same. China is rebalancing its economy, from industry to services, to try to avoid the middle income trap. This is causing the economy to grow slower than before, and there are doubts about the sustainability of the chinese growth. All this is making investors nervous, and China needs a way to reassure them that there is nothing to worry about. So, to reassure investors, the marketing coup is the inclusion of the chinese yuan in the SDR, same as the entry in the WTO was the marketing coup in 2001. And western countries, again, make an exception with the idea of forcing China to accelerate reforms.
And it’s good marketing for the party too (and Xi Jingping), especially now that the economy is growing less, Chinese people are complaining and they need all the good news they can get.
So what will happen? In the short term, there are banks like Merril Lynch that say that the CNY is overvalued and will devaluate up to 10% in the next year. I don’t think it will be that much, it basically depends on the interest rate that the FED decided for the USD, and the movements of the USD. If the USD goes up, the CNY will devaluate for sure, probably keeping more or less stable against the EUR. This means, for these of us who buy from China in USD, that prices would go down by 10% (in USD!).
In the mid term, it’s clear that reforms of Chinese capital markets will accelerate. So it’s very likely that in a few years we will be able to trade with China directly in Chinese Yuan. Also the CNY will be more used and easier to trade, so it will better reflect the shape of China, and not so much the will of the party as it does today.
It’s clear that the CNY is overvalued, as it’s pegged to the USD, which has appreciated a lot this year. Reforms will come, but China will not suddenly open the capital markets. So for the moment the valuation of the CNY will continue being linked to the party’s wishes.