1. 1
1Q 2015
2015
AB FIXED INCOME INSIGHTS
BEYOND SDR: CAPITAL INFLOWS ARE
CHINA’S NEXT CHALLENGE
+ Hayden Briscoe, Director—Asia Pacific Fixed Income
The likely escalation this month of China’s currency to reserve status will be symbolically important
for the Chinese government. Behind the expected headlines and celebrations, however, other
developments may be about to have a bigger impact on investors.
China’s reforms are proceeding apace on so many fronts that
it’s easy, sometimes, to lose sight of the big picture. On
November 30, for example, the International Monetary Fund is
expected to admit the renminbi (RMB) into its basket of reserve
currencies, or Special Drawing Rights (SDR).
This will be a significant step in the internationalisation of the
currency and will further enhance the RMB’s status in the eyes
of global currency markets. We think it’s better understood,
however, as a detail on a broader canvas of government
reforms.
While the RMB’s inclusion in the SDR is likely to stimulate
capital inflows as central banks buy more of the currency for
their reserve accounts, the inclusion needs to be seen in the
context of the opening up of the country’s capital account,
which began in July.
In our view, the flow-on effects of capital account liberalisation
will have a much broader impact on China’s capital markets
and on investors in China than the inclusion of the RMB in
SDR per se. While SDR rebalancing by central banks could
account for flows of around US$42 billion, our research
suggests that capital account liberalisation as a whole could
account for flows closer to US$3 trillion.
We expect the long-term effects to be positive, but they could
cause disruption in markets and pose some challenges for
China’s financial authorities in the short-to-medium term.
US$3 TRILLION LOOKING FOR A HOME
In a little-publicised move, China announced in July that it
would allow central banks, sovereign wealth funds and
supranational organisations to access the Chinese bond
markets directly and without quotas. The move helped to
improve the RMB’s convertibility and make it eligible for
inclusion in the SDR.
We estimate that these institutions between them control
assets of US$30 trillion, and we are noticing increasing
evidence of their activity in China’s government bond market.
Based on our knowledge of their typical asset allocation
patterns, we expect them to invest a combined US$873 billion
in the government bond sector.
As the liberalisation of the capital account continues,
international pension plans will also begin making allocations to
China’s bond and equity markets. These investors use market
indices, so the indices will be adjusted to include Chinese
securities. This development has been in the wings for some
time and progressed earlier this month when MSCI announced
that it would add foreign-listed Chinese shares to one of its
emerging-market indices.
These developments, together with private and public
investment in risk assets (equities and corporate bonds),
comprise our total estimated flows of nearly US$3 trillion.
RMB STABILITY WILL BE THE KEY
While all this is positive for China in the long term, it does
create potential headaches for authorities in the immediate
future. To put this in perspective, investors have been worried
recently about capital outflows from China totalling around
US$250 billion.
These are in fact quite small for a country with foreign currency
reserves of US$3.5 trillion. The bigger question is, how will the
country cope with inflows of US$3 trillion? What will be the
impact on domestic liquidity, and how will the PBOC sterilise it?
The central bank, in our view, will face a major challenge in
managing these inflows. We expect that its response, in part,
will be to focus on managing the currency, as a stable
exchange rate would be a key factor in maintaining some
balance between capital inflows and outflows.

2. 2
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