As we discussed a few weeks back, the broad market anticipation that RMB would be confirmed as a member of the Special Drawing Rights basket of IMF reserve currencies. As we mused in our preview to the meeting, the IMF did plumb for a RMB 10.9% weighting versus USD 41.73%, EUR 30.93%, JPY 8.33%and GBP 8.09%. The decision broadly translates to Reserve Manager purchases of circa $30bln RMB to be transacted by October 1st 2016. The additional and more important aspect of the inclusion is the IMF’s recognition of China’s efforts to liberalize the RMB.
Medium To Long Term Implications
From a market structure perspective the inclusion decision is a big stamp of approval for the Peoples Bank of China’s (PBOC) policies and the reform measures they have implemented. The PBOC have been working diligently to preparing the way for the RMB to meet the IMF standards for the SDR. Many market watchers are of the view that the SDR inclusion has similar implications to China joining the World Trade Organization back in 2001, which had broader implications over the following years for global trade, the initial impact was minimal, but there was a significant structural shift in trade flows that emerged in the following three to five years, and the currency impact is anticipated to have a similar effect in FX markets over coming years.
A key constituent of the IMF’s continual assessment criteria for inclusion will be a stringent requirement for China to facilitate international access to onshore markets. This stipulation is premised on the notion that Reserve Managers will demand access to the more liquid onshore markets to transact buy and sell orders in RMB, specifically they will require access to alternative RMB denominated assets providing them with an ability to hedge RMB exposure.
A further implication of the IMF rubber stamping is that political support should strengthen for global benchmarks to increase the weighting of China assets in the MSCI, which over time will also encourage capital inflows. Global funds remain under weight RMB assets on a ratio basis, considering the scale of China’s economy and hence there will be a move to broaden exposure in the medium to long term.
As liberalization measure take pace there will be a follow through to interest rate liberalization which will have the immediate implication of enhancing the liquidity of the domestic bond markets, which will further encourage international capital inflows. Under the current regime China’s interests rates are not truly market driven, often volatile at best mispriced at worse manipulated. As the these underlying markets become increasing transparent and more market driven pricing infiltrates these bonds, the attractiveness of the RMB will increase exponentially which in turn will lead to the weighting of the RMB increasing, taking share from the USD and EUR.
Near Term Implications
With the medium to long term perspective understood we turn our attention to the near term implications of the IMF decision. The move to liberalize the currency and open capital account access has a give and take effect in the near term, the flows will not be one way for now.
The current market climate and economic cycle suggest the RMB is most likely to weaken further in the near term, as Chinese fundamentals versus US fundamentals are divergent with a negative skew. The PBOC has been fighting the flows recently in an attempt to stem the the rise of USDCNY as they endeavor to bridge the spread between the onshore and offshore currency. Now they have defended any market event around the SDR decision and kept the spread within an acceptable band, it is most likely that post the December FOMC meeting the PBOC will withdraw from direct intervention measures, allowing the USDCNY to trade on fundamental drivers.
The PBOC pulling back from direct intervention in the markets is a key criteria for the IMF assessment, as the IMF require the USDCNY to trade on fundamentals so the CNY weighting in the SDR basket can be more accurately weighted over time. This will also have a derivative effect on other Asian FX centers, as over the past five years the PBOC has been a large buyer of Asian FX and Bonds, as they sought to diversify their USD holdings, those purchases will most likely decline now.
Trading Take Away
I didn’t get an entry to on the long side in the USDCNY with the price pattern I was mapping, as such I have updated my market map. I am anticipating a test of the resistance zone highlighted in the chart below. I will be looking or an equidistant pullback which will retest prior highs at 6.36 where I will be looking to get long targeting the topside of the projected channel at 6.49.
Open Emerging Market FX Trades
Long USDINR 65.25 Stops To Entry, First Target Achieved at 66.85, stay long to target a retest and break of year to date highs next
Long USDBRL as per my plan long through 38000 stop below 37400. I am now moving my stops to entry on this trade.
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