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SDR inclusion to help China lure trillion-dollar inflows

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China could see inflows of as much as $3 trillion into renminbi assets over the medium-to-long term as successful inclusion of the yuan in the International Monetary Fund's (IMF) reserve currency basket sets the stage for further opening of the country's financial markets.

Monday's momentous decision will see the Chinese yuan (CNY) hold a 10.9 percent weighting in the Special Drawing Rights (SDR) basket, higher than the yen (Exchange:JPYUSD=)and sterling's (:GBPUSD=)8 percent but well below the euro's (:EURUSD=)30.9 percent and the greenback's (New York Board of Trade (Futures): =USD)42.9 percent.

"This should help underpin China's continuing efforts to internationalize the currency and its capital account-moves which, our research suggests, could lead to inflows of up to $3 trillion over the next few years," said Hayden Briscoe, managing director of Asia Pacific fixed income at asset manager AllianceBernstein (AB), on Tuesday.

Morgan Stanley meanwhile expects inflows to top $2 trillion over ten years, with flows from foreign exchange reserve managers making up the largest share, according to a Tuesday report.

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But strategists are quick to point out that these inflows don't hinge just on Monday's news.

Rather, the announcement strengthens the hand of Beijing's overall financial reform agenda, which will be the key factor luring global portfolio managers, AB noted.

Bank of America Merrill Lynch estimates yuan demand created by IMF members rearranging their SDRs to be worth $35 billion, not a particularly large number for an economy of China's size.

The potential entry of Chinese A-shares into MSCI's Emerging Markets (EM) Index and relative attractiveness of renminbi assets will be the larger drivers of medium-to-long-run inflows into China, Morgan Stanley added.

While the IMF's decision acknowledges China's economic ascendance and financial liberalization achieved thus far, it's unlikely to impact MSCI's decision. Earlier this year, the index provider told Beijing that it must make greater progress on capital account liberalization before including A-shares into its global benchmark.

"The reforms China has undertaken/will undertake to achieve SDR status could help in issues like market access and liquidity, factors that index providers consider for membership," Morgan Stanley explained.

MSCI has already added U.S. listed shares of Chinese stocks , such as Alibaba and Baidu (BIDU), to its EM index.

Because the IMF's move is more of a symbolical development that enhances the renminbi's prestige as an international currency, little immediate impact on Chinese bonds and stocks is expected.

Indeed, the benchmark Shanghai Composite (Shanghai Stock Exchange: .SSEC) swung between gains and losses in early Tuesday trade while the currency was flat at 6.3982 against the dollar.

"What really matters is whether central banks and sovereign wealth funds start to see the renminbi as a viable store of liquidity and of value to rival the U.S. dollar. Such a shift seems unlikely while doubts persist over China's prospects for a smooth and orderly rebalancing, and while China retains widespread capital controls," explained Andrew Colquhoun, head of Asia-Pacific sovereigns at Fitch Ratings, in a note on Tuesday.

Surveys released on Tuesday showed China's crucial manufacturing sector remained in a funk in November , casting more gloom about the economy's recovery.

Global central banks don't strictly follow the SDR weighting so they don't need to increase their yuan holdings right away, noted Becky Liu, senior rates strategist at Standard Chartered Bank.

Rather, the trend will happen gradually as central banks look to diversify away from G-10 currencies, she said, adding that she expects a 1 percent annual reallocation of global FX reserves into China on an annual basis in the coming five years.

Aside from central banks, multilateral institutions, such as the Bank of International Settlements, the World Bank and the Islamic Development Bank, could also impact yuan inflows since their portfolios are benchmarked against the SDR basket, Liu explained.

"Their portfolio size is more than half a trillion dollars so with the renminbi's new 11 percent weighting, their contribution to the reallocation of renminbi assets is more than $60 billion."



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