Last week, the International Monetary Fund (IMF) voted to admit China’s renminbi currency to the Special Drawing Right (SDR) starting October 1, 2016.

Its 10.92% weighting will be the third largest in the world.

In the short term, the renminbi – which currently represents 2% to 3% of world trade – will rapidly increase its trade share towards its percentage in the SDR. In the long term, it’ll also change China both politically and economically in ways its leaders may not expect.

Opening the Flood Gates

Basically, the IMF encourages the use of the SDR as a payment and accounting mechanism.

Hence, countries whose currencies are included in the SDR take on a nebulous web of obligations involving the currency’s use in international trade and the lack of manipulation by its government.

And while China is more than happy for the renminbi to be used in international trade, it still places severe restrictions on domestic Chinese residents exchanging renminbi for foreign currencies.

To some extent, this reflects the mentality of a country that has always had a foreign exchange shortage. But it also reflects the desire of the Chinese government to maintain some control over its currency and domestic markets.

When the Chinese banks get in trouble or the government runs a big budget deficit, it’s convenient for the government to have the gigantic domestic pool of Chinese savings available to finance deficits and banking problems at favorable interest rates.

But Japan has shown where this can lead – an economic dead-end.

Japan abolished exchange controls for domestic residents in 1980, but kept much of the nation’s savings and pension entitlements in a government-owned entity, the Japan Post Bank, which bought primarily government bonds.

After the crash and liquidity crisis of the early 1990s, Japan’s government was able to borrow much more cheaply than its private sector, leading to 20 years of massive budget deficits and wasteful state infrastructure spending, which in turn has led to economic stagnation.

By giving its citizens alternatives to government bonds and the state-owned oligopoly of domestic banks, China will both ensure that its massive savings pool is optimally deployed and also exert useful discipline on state bureaucrats and bankers.

The result should be that China’s growth continues at a rapid pace even beyond its current “middle-income” level of wealth, at which growth becomes more difficult (because the country is no longer the most efficient source of cheap labor).

Opening China’s capital account is the next step needed for China to become a truly prosperous free market economy on Western models.

The other major effect of the IMF’s action, and the consequent opening of China’s controls on domestic savers, will be on China’s stock market.

Currently, Chinese companies trade on two stock exchanges – Shanghai (or Shenzen, another domestic Chinese exchange) and Hong Kong. Shanghai “A” shares are open to domestic Chinese investors, whereas Hong Kong-listed “H” shares are open only to foreigners (there has been a slight relaxation of these regulations in recent years, but they remain basically in place).

However, share prices on these two exchanges are widely different.

The Shanghai market has an average P/E ratio of 18 times (still below the 19.9 times of the Standard and Poor’s 500 Index), while the Hong Kong “H” share market trades on an average P/E of about 11 times.

Thus, once exchange controls are removed, domestic investors can freely buy shares on Hong Kong and foreign retail investors can freely buy shares on Shanghai and Shenzen. The two markets should arbitrage, with “H” share prices rising and “A” share prices declining to meet them.

Ride the SDR to Profits

Now, China isn’t a slam dunk “sell everything and put your retirement fund in” investment.

For one thing, the spate of government-directed lending in 2009-10, to overcome the 2008 recession, has left far too many “white elephant” office buildings in Chinese provincial cities, which will all have to be written off the balance sheets of banks who lent against them.

Thus, at some stage in the next few years, China is likely to go through a fairly severe credit crisis.

Still, overall it’s probably worth having some of your money in China, though I wouldn’t go quite as far as matching the IMF’s 10.92% allocation.

Given that China will likely relax exchange controls over the next few years, the obvious vehicle is the Guggenheim China Small Cap ETF (HAO). HAO invests in the H shares listed on Hong Kong and attempts to match the AlphaShares China Small Cap Index.

HAO is a $146 million fund with a reasonable expense ratio of 0.75% and a yield of 2.2%. It trades at an average P/E of 11 times earnings. Plus, HAO avoids the largest Chinese state-controlled companies, which are heavily politicized and full of bad assets. It will therefore benefit from any arbitrage between “H” and “A” shares.

Bottom line: The renminbi’s entry into the SDR is good news for China. And if China carries out the reforms the IMF expects, it’ll become very good news for China.

Good investing,

Martin Hutchinson