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Yuan inclusion in SDR basket unlikely to boost Chinese bond market activity

Theyuan will officially join other major global currencies in the IMF's SpecialDrawing Rights basketOct. 1, but foreign investors are unlikely to rush to hold moreyuan-denominated assets.

The Chinesecurrency will become the fifth currency in the SDR basket, alongside the U.S.dollar, the euro, the Japanese yen and the British pound. This is the firsttime a new currency has been added to the currency basket since theintroduction of the euro in 1999.

Theyuan will carry a weighting of 10.92% in the basket, behind the U.S. dollar andthe euro, which have weightings of 41.73% and 30.93%, respectively. The IMFmanages the SDR as a supplementary reserve asset, and the value of the currencybasket is set and published daily.

The onshore bond market could benefit from the yuan'sinclusion, as funds tracking the SDR basket and sovereign wealth funds willincrease holdings of the Chinese currency or yuan-denominated financialinstruments, though the impact has been limited so far.

Sincethe IMF announced the decision in November 2015, the volume of domestic yuanbonds held by overseas entities has increased slightly to 763.98 billion yuanas of June from 751.71 billion yuan as of the end of 2015.

Thatmild increase could have been driven by investment funds riding on positivesentiment from the IMF decision, but the overall impact on the bond market hasbeen small, said Iris Pang, Greater China economist at Natixis.

Downthe road, foreign institutional investors will remain reluctant to invest inthe onshore bond market due to a variety of concerns ranging from capitalcontrols, to the yuan's depreciation, to a lack of derivative products to hedgeagainst currency and interest rate risks, she said.

"Thingscannot be done without further bond market development. The inclusion of theyuan into the SDR basket is not a magic tool," Pang said.

China'sfinancial regulators have taken steps to encourage capital inflow to the onshorebond market. In July 2015, the People's Bank of China said foreign centralbanks, international financial organizations and sovereign wealth funds areallowed to invest in the Chinese interbank bond market without needing to seekapproval or having to adhere to quota limits.

Thecentral bank in May further expanded the scope of foreign investors grantedaccess to the bond market, including commercial banks, insurance companies andasset management firms, among others.

Theinclusion of the yuan may help to make the onshore interbank bond market moreliquid, but that will be a very long term and slow process, said Andy Leung, abanking analyst at KGI Securities.

Chinahas moved to liberalize the use of its currency in order to meet theIMF's "freely usable" rule. The yuan's trading band was widened toallow for more flexibility, and the Chinese central bank has granted someforeign central banks and sovereign wealth funds access to the interbankforeign exchange market to conduct yuan and forex trading.

Butthough the addition of the yuan to the SDR basket will mark a milestone inChina's long-standing desire to boost the prestige and usage of the currency,many important steps still need to be taken.

"Theinclusion of the yuan into the SDR is mostly symbolic, rather than arepresentation of a major shift in international usage of the yuan," saidLynn Song, an economist at China Merchants Securities.

Theyuan is the world's fifth-most-used currency, representing 1.86% of globalpayments by value as of August, according to interbank messaging systemprovider SWIFT. Its usage lags the U.S. dollar, which accounts for 42.50% ofglobal payments and remains a firm No. 1.

Theaddition of the yuan to the SDR basket reflects its acceptance by major globalfinancial institutions. But in order for the yuan to become even more widelyused, the currency needs to become freely convertible, which requires aliberalized capital account, Song said.

Thisis unlikely to occur in the near future as the outflow of capital from Chinawill worsen if the capital account is fully open, especially when the yuan isdepreciating, Natixis' Pang said.

"Gold is quoted in U.S. dollars, oil is quoted in U.S.dollars, when will they be quoted in yuan? China has this vision for itscurrency, but to realize this, the yuan first has to be freelyconvertible," she said.

As of Sept. 29, US$1was equivalent to 6.67 Chinese yuan.