Official institutions readying for SDR launch

Institutions with SDR exposures, such as central banks, sovereign wealth funds, supranational and multilateral institutions, have had ten months to prepare for the launch of the new basket, where the RMB will be the only new currency added, with a weight of nearly 11%, to join the dollar, euro, yen, and pound.

For central banks, the arrival of the date won't necessarily bring any unexpected commotion.

"The date of October 1 does not mean much for most central banks," said Pihlman in a phone interview. "More than 70 of them were already invested in RMB before its inclusion, but now that just opens it up for central banks that were kept out before because of the indirect implication of the RMB becoming an official reserve currency."

Yet, while these institutions have had the ability to ready themselves, by either shifting portfolio allocations to include a greater portion of RMB assets, or by building hedging positions to protect from the foreign exchange risk of their indirect RMB exposure via the SDR, the mechanics of the transition will only effectively play out this Friday and Saturday.

Pihlman did not exclude the possibility of more trading activity in RMB markets on the official launch date, but noted most institutions would proceed cautiously.

"There may be more trading on that day, but it is unlikely that those that will make a discretionary allocation would have to deal or trade around the exact date. They can gradually change the allocations over a period of time, as it is completely discretionary, and it never makes sense to do large chunk of transactions on any day given the possibility of moving the market."

One practical application of transition will be for SDR loans involving the IMF. Starting October 1, the IMF will be able to choose to issue those loans in RMB, while loan recipients can be asked to repay the loans in RMB, which might create additional demand in the market.

This means that, from the perspective of institutions involved in IMF loan programmes, getting prepared to transact in RMB will become a necessity. As a result, StanChart’s Pihlman noted the bank has encouraged clients to go through the necessary steps allowing them to transact in onshore RMB (CNY) and offshore RMB (CNH).

The setup is under way, at least for some. The China Foreign Exchange Trading System (CFETS), a pillar of the China interbank trading infrastructure under the People’s Bank of China, has issued notices of admissions for a number of foreign official institutions. On September 21, for example, CFETS said that the Arab Monetary Fund, Central Bank of Jordan, Central Bank of Iraq and the State Bank of Pakistan were the latest batch of entrants to the interbank FX market.

Brand new fix

But for institutions to start using the new basket, new rates will have to be set.  For that to happen a few things need to take place on September 30.

At noon London time, the Bank of England will issue, via the IMF, a quote for the CNH-dollar pair, which will contribute to the first official fixing of the new SDR. At 4 pm London time, a reference quote will be issued by the IMF based on the CFETS afternoon fixing rate of the CNY against the dollar.

The possibility exists that the two rates could diverge, due to the time interval between the fixes and to the fact that the onshore and offshore RMB continue to trade at a spread. As of the close on September 28, the CNY was trading at 6.67012, 132bp tighter than the offshore rate, according to Wind data.

Pihlman said while the issue did not present practical problems as institutions had access to both markets with no restrictions, the spread remained a point the regulators' agenda.

"It is clear the Chinese authorities want the spread to disappear and eventually it will. It will happen once there is more cross-border activity and it can be arbitraged away. For the official institutions participating in the FX market, they have no restrictions, they can do simultaneous transaction onshore-offshore. But this is not what public sector investors typically do, so the rate difference can remain for a while."

Scheduling issues

At the same time, institutions will need to be mindful of the fact that, possibly as the result of a scheduling oversight on the IMF's part, the week starting October 3 is a long holiday in China following the PRC National Day on October 1.

This means that transactions conducting in the onshore market on September 30 will not be settled until as late as October 10. As a result, any SDR-related transactions are more likely to happen in the international CNH market until mainland China reopens for business.

In terms of the SDR interest rate applicable to loans, the first rate under the new basket will not be published until October 7. The current rate has been at the IMF mandatory floor of 5bp for some time, given that the underlying rates - which include European and Japanese negative interest rates - would have brought the effective rate below zero.

While last November, when the IMF decided to include the RMB, it was thought the RMB inclusion would boost SDR rates substantially, trends in the onshore bond market, where rates have consistently fallen, mean that the new SDR interest rate is unlikely to move upward by much.

"My back-of-the envelope calculation is that there will be only a modest positive change in the SDR interest rate, not a dramatic one,” said Pihlman. “As of [September 26], that would be just under 10bp. But this is just a reference rate, as there will be margins. But the implication of RMB inclusion on SDR interest rate is smaller than anticipated."