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China's yuan may turn out to be the world's third largest reserve forex in 10 years, Morgan Stanley predicts

A Chinese bank teller counts 100 yuan bills and US dollar bills at a bank counter in Nantong, east China's Jiangsu Province, on Aug. 6, 2019.

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Increased foreign investment in Chinese markets could boost the use of the yuan and make it the third largest reserve currency in the world after just the US dollar and the euro, Morgan Stanley analysts forecast in a report distributed on Friday.

The prognosis is that the Chinese government has been trying for years to encourage the international use of the yuan, also known as the renminbi (RMB).

Currently, the yuan accounts for around 2% of global foreign exchange reserves, the report said. However, by 2030 it could rise between 5% and 10%, outperforming the Japanese yen and the British pound, analysts said. The forecast repeats one the bank made in February 2019.

In the 18 months since then, the Chinese government has stepped up efforts to bring more foreign financial institutions to the domestic market. Foreign investors are also increasingly turning to the Chinese market in order to exploit the potential for relatively higher returns than in other regions.

Investment portfolio inflows will become more important than FDI for cumulative inflows of $ 3 trillion over the next decade, Morgan Stanley projected.

"We expect private and reserve managers to generate more than $ 150 billion in portfolio inflows into China in 2020 for the third year in a row, highlighting ongoing transformations. Annual inflows are expected between 2021 and 30,200 up to $ 300 billion. " Report said.

These investments will hold more global yuan assets that have struggled to gain a foothold internationally. The Chinese government has traditionally had a tight grip on the currency, including preventing large amounts of capital from leaving the country.

In 2015, however, the International Monetary Fund took the politically significant step of adding the yuan to its basket of major reserve currencies – the so-called special drawing rights basket. The yuan was added to the IMF's basket in October 2016.

Morgan Stanley forecast the yuan is expected to rise to 6.6 yuan against the US dollar by the end of 2021. The Chinese yuan was trading near 6.85 yuan against the dollar on Friday.

"(The 5% to 10% target) is not unrealistic given the opening of China's financial markets, the growing cross-border capital market integration we are seeing in stocks and fixed income, and an increasing proportion of cross-border transactions in China denominated in RMB "International strategist James Lord of Morgan Stanley said in the report. "All of this suggests that global central banks need to hold more RMB as part of their reserves."

"By the end of 2019, there are around 70 central banks in the world holding RMB in their reserves, up from 60 at the end of 2018, according to the PBOC's annual RMB internationalization reports," said Lord, referring to the People's Bank of China, the country's central bank.

I remain very skeptical of a dramatic rise in the RMB as a major reserve currency.

Michael Pettis

Professor of Finance at Peking University

The analysts' thesis also incorporates changes in China's economic drivers – above all the dependence on exports for growth – which make it necessary for the country to become a capital importer. The report estimates the country's current account, which includes trade and payments to foreign investors, will turn negative from 2025 and could reach negative 1.2% of GDP by 2030.

"This means that between 2025 and 2030, at least $ 180 billion in net capital inflows will be required annually to fund the current account deficit," the report said.

Possible risks

It remains to be seen how central banks and investment institutions deal with political pressure in the allocation of their holdings. Tensions between the world's two largest economies that have started trading have impacted both technology and finance in the run-up to US President Donald Trump's re-election in November.

"I remain very skeptical of any dramatic increase in the RMB as a major reserve currency," said Michael Pettis, a professor of finance at Peking University, in an email.

"I don't think there is any reason to disagree with Morgan Stanley's current account projections, but I would find it very difficult to make long-term predictions about how China's current account will develop," he said. "The scale of the adjustment China will have to make to rebalance sources of demand in its economy is significant, and each of the historical precedents suggests that the adjustment will involve a transformation of economic (and possibly political) institutions . "

However, Morgan Stanley noted that their prediction that the yuan will gain traction internationally carries several risks. These include a slower-than-expected opening of China's financial markets to foreign investment, volatility in global markets, China's economic risks and a significant escalation in US-China tensions.

"Another area where we could be wrong is the trend of the internationalization of the CNY (Chinese yuan) and the willingness of reserve managers to add CNY bonds to their portfolios," the report wrote. "After all, most of the increase in China's share of reserve assets so far has come from Russia, and it is not yet clear how others will follow suit, especially if the wider economy does not open up in time."

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