Recently we have seen China speed up its race to deregulate its currency. The ultimate objective is the ‘internationalization’ of the Yuan, which basically means that China wants much broader use of its currency around the world, in synch with the global economic order. Today, China accounts for more than 10% of world trade but only 3% of global payments are in the CNY.

A quick path for this broader use is to receive membership in the IMF’s SDR (Special Drawing Rights). The membership decision takes place only once in five years and is happening toward the end of this year. The SDR is a basket of only four currencies – the USD, EUR, GBP and JPY – and the basket is held only by central banks as a reserve asset. There are only two criteria to join the SDR: 1) that the currency must be that of one of the world’s top exporters over five years, and 2) that the currency is ‘freely usable.’ It is this latter criterion that the CNY still does not meet.

With warnings from the IMF back in August, we still vividly remember the abrupt devaluation of the CNY that took place back then by the People’s Bank of China which also pledged to give the market a bigger role in determining its exchange rate. Since then the market has settled and just over this past week, China has vowed that it would overhaul its FX management making the CNY freely convertible by 2020, relaxing interest rate controls so that its financial institutions become more competitive, and linking the Shenzhen and Hong Kong stock exchanges this year.

Eventually central banks, investors and corporates will need to hold more money in the CNY reducing the other currencies that they are predominantly holding as a reserve currency today. Some analysts estimate that CNY’s SDR approval would draw about $1 trillion of global money in a shift into Chinese assets.

The race to deregulate its currency also comes at an important time, as it may slow some of the massive capital now coming out of China. As the Chinese economy is slowing down and the strong USD is putting pressure on the CNY, the Chinese wealthy are continuing to invest overseas at unprecedented levels.

My View:  This deregulation process is the right direction for both China and the rest of the world. Less currency control by the number two economy means that any artificial values will be correcting.  However, there is still a very long way to go as China’s domestic capital markets have not developed.  Free markets will open the door to heightened volatility and risk. Therefore, it is important to keep the long-term vision intact, but there is probably not a huge short-term market impact.

City National Bank would like to welcome the concluded merger with the Royal Bank of Canada, as we continue to be a safe and sound bank, with access to larger international capabilities.

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