The elevation of China’s currency to reserve status is symbolically important for the country, but it’s only part of a process that could trigger capital inflows of up to US$3 trillion—and cause some headaches for the country’s financial authorities.

As expected, the International Monetary Fund announced that China will form part of its reserve currency basket, known as the Special Drawing Right (SDR), starting October 1, 2016.

This is a significant step in the internationalization of the currency, and will further enhance the status of the renminbi (RMB) in global currency markets. We think it’s better understood, however, as a small detail on a broader canvas.

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 within 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 liberalization will have a much broader impact on China’s capital markets and on investors in China than the inclusion of the RMB in the SDR per se. While SDR rebalancing by central banks could account for inflows of around US$42 billion, our research suggests that capital-account liberalization as a whole could account for inflows 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-publicized move, China announced in July that it would allow central banks, sovereign wealth funds and supranational organizations 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 between them, these institutions 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 these institutions’ typical asset-allocation patterns, we expect them to invest a combined US$873 billion in the government bond sector.

As the liberalization of China’s 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 works 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 inflows of nearly US$3 trillion.

RMB Stability Will Be Key

While all this is positive for China in the long term, it does create potential headaches for financial 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 outflows 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 People’s Bank of China sterilize 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 will be a key factor in maintaining some balance between capital inflows and outflows.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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