Guest Commentator of CFETS, Sep 29, 2016
Currently, the People’s Bank of China has announced through Weibo that: “On October 1st 2016, the RMB will officially join the International Monetary Fund （IMF） Special drawing rights (SDR) currency basket. Recently, a number of Foreign Central Banks and similar institutions (including some International Financial Organizations) and financial institutions started to increase their positions in China’s domestic RMB bond assets. The relevant service institutions in China’s interbank bond market will continually offer facilities.” At the time of RMB being included in the SDR currency basket, this indicates an increasing demand for RMB bond assets from international institutional investors, and the corresponding capital inflows will contribute to the stability of RMB exchange rate.
At present, the driving forces for the foreign institutional investors to purchase RMB bond assets mainly come from four aspects: Firstly, since RMB joins the SDR currency basket, those foreign institutional investors who already have SDR asset positions need to adjust their reallocate assets accordingly. Some Foreign Central Banks may also hold more RMB as their reserve assets. Both of these reasons bring the demand for purchasing RMB and RMB bond assets. Secondly, RMB assets are preferably appealing to international investors for higher yield rates. Since the financial crisis in 2008, major developed economies keep implementing easy monetary policy, which results in consistent low yield rates in money and bond markets, and the total amount of negative interest rate bonds has climbed to 13 trillion US dollars globally. By contrast, the interest rate level in China is substantially superior to developed economies. Basically speaking, the spread of 1Y treasury bonds returns between China and Untied States maintains above 150bps. In addition, the sovereign credit rating of China is higher than other emerging economies. Therefore, China’s bond market is quite attractive to international capitals. Thirdly, persistent financial reforms promote the attractiveness of China’s domestic financial markets. On one hand, the market-oriented reform of foreign exchange rate is moving forward continuously, the level of regularity, transparency and market-orientation of RMB exchange rate formation mechanism is constantly improving, which leads to a stronger elasticity in USD/CNY exchange rate, as well as more stable RMB exchange rates against a basket of currencies. This stability boosts confidence of foreign investors to purchase and hold RMB assets. On the other hand, the People’s Bank of China has introduced a series of opening-up policies in China’s FX market and bond markets, providing abundant financial products for managing FX and interest rate risks, which facilitating foreign investors in FX trades and hedging risks. Fourthly, alone with the further development and opening-up of Chinese domestic financial markets, Chinese bond market is expected to be incorporated into primary global bond indices，which about 5 trillion US dollars are tracking to asset allocation. And Chinese A-share market is also expected to be incorporated into primary global stock indices, tracking by around 1 trillion US dollars. These practices contribute to appealing more international capitals to allocate China’s domestic bonds and stocks.
Foreign investors’ purchasing RMB bonds contributes to promoting long-term capital inflow. Because, buying RMB is a necessary step of allocating assets in China’s domestic RMB bonds, such allocation will bring capital inflows. Since the majority of targeting foreign institutional investors are mid to long-term investors, their entrance could effectively increase long-term capital inflows. Meanwhile, more and more foreign institutional investors entering China’s interbank bond market may also promote the market’s development. This could be realized by the introduction of more diversified investment demand and strategies, as well as the improvement of the standard of services and international competitiveness of local market participants and infrastructures. What is more, a continued increasing of foreign institutional investors’ demands may help lowering social financing costs, supporting the growth of real economy and strengthening the economic fundamentals. All these contribute to building a more attractive market and macro economic environment，creating a benign cycle and in turn, bringing about more long-term capital inflows.
Predictably, with RMB being formally included into the SDR currency basket and the progressing of the opening up of China’s financial markets, the capital inflows resulted from foreign investors purchasing RMB assets will constantly contribute to stabilizing RMB exchange rate. By the end of August, 2016, the outstanding amount of Chinese bond market was 59.5 trillion RMB, among which only less than 2% was hold by foreign investors. This proportion is not only far below the advanced economies’ average level, which is about 20%, but also significantly lower than the average level of emerging economies, which is about 10%. From this view of point, there is still enormous room for the growth of foreign investors’ investment in China’s interbank bond market. As a result, the huge RMB demand derived from foreign investors’ investment, together with China’s considerable trade surplus, will generate large amount of FX supply, providing continuously supports to RMB exchange rate. Along with the nearly completed de-leveraging process for the foreign currency denominated debt, as well as the leveling out of the growth of ODI, the capital flows in China will trend balance.
Overall, the FX formation mechanism of China will remain unchanged after RMB has officially joined the SDR currency basket. China will continue to operate the managed floating exchange rate regime, which is based on market supply and demand and with reference to a basket of currencies. Meanwhile, given the fundamentals of the medium-high speed of economic growth, the relatively large trade surplus, the continually increase in the FDI, the abundant foreign exchange reserve and the balanced capital flows, RMB exchange rate will be more capable to keep stable against a basket of currencies.
