China’s currency is set to take an increasing share of world foreign-exchange reserves, with the dollar and yen having to make the most room proportionally for the newcomer on the block, according to Goldman Sachs Group Inc.
An acceleration in foreign inflows into Chinese fixed income in recent months — despite a tumble in the yuan — has showcased the power of allocation demand for the world’s No. 3 bond market. Central banks will probably account for $250 billion of an estimated $1 trillion of net inflows into Chinese bonds in the five years through 2022, Goldman analysts said.
“Reserve re-allocations (i.e., outflows) could be more concentrated in dollars and yen,” analysts Danny Suwanapruti, Michael Cahill and Andrew Tilton wrote in a note Friday. Because central banks already hold the bulk of their reserves in dollars, the greenback is a natural funding source. “The rise in the renminbi’s prominence should impact the yen more since it will no longer be Asia’s only reserve currency,” they wrote, using another term for the yuan.
Along with reallocation from index-following asset managers that are set to respond to China’s inclusion in major global bond benchmarks, some $522 billion will come out of other markets into Chinese fixed income over five years, Goldman projects. For ease of analysis, that’s under the assumption of assets under management being static. A total of $1 trillion will flow in, including sovereign wealth funds and private fund managers, the bank said.
Outflows from Japan thanks to central banks and bond-index followers are estimated at $66 billion, which represents about 12 percent of foreign holdings of Japanese government bonds. The similar figure for U.S. bonds is $280 billion, though that only amounts to about 4 percent of foreign holdings of Treasuries, Goldman calculated.
China has been steadily opening its domestic markets to overseas investors, as part of a broader attempt to secure a stable exchange rate, given pent up demand among Chinese households and companies to put money overseas. Just last week, the State Council decided to exempt foreign institutions from some taxes.
The yuan’s share of global reserves, as identified in International Monetary Fund allocation estimates, “should rise to around 3 to 4 percent by the end of 2022,” the Goldman analysts wrote. “If financial markets deepen faster than we expect, then these estimates could prove to be too conservative. However, there are also a number of downside risks, including the fact that reserve allocation decisions tend to be rather ‘sticky.'”
For now, the outlook is for the yuan to remain below the pound and the yen in global reserves, Goldman concluded.