* Investors look to rise of yuan, EM FX in reserves
* Convertibility hurdle could be overcome
* IMF could review SDR basket at any time
By Carolyn Cohn
LONDON, May 26 China's yuan and its emerging economy peers could become reserve currencies sooner than many investors think, as some experts reckon the hurdles of convertibility and policymaker inertia are easily negotiated.
China and other countries from the BRICS nations -- Brazil, Russia, India and South Africa -- would like their currencies to make up part of the International Monetary Fund's special drawing right (SDR), which is used as a reserve asset.
Chinese officials have asserted that widening the SDR basket would heighten the yuan's profile as a potential reserve currency, with some experts seeing the SDR growing into a partial substitute for the dollar.
The SDR, now composed of just U.S. dollars, euros, British pounds and Japanese yen, broadly reflects the composition of the $9 trillion held in global central bank reserves.
The SDR makes up 4 percent of those reserves due to allocations by the IMF, the most recent being in 2009.
To the extent that the SDR reflects these holdings, any change to its make-up could help significantly rebalance those reserve savings.
The issue of entry into the SDR has been debated at recent BRICS and G20 meetings, as part of discussions on reform of the international monetary system. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Graphic on IMF reserve composition r.reuters.com/gag79r ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>
Dampening hopes for an early widening of reserve currencies, the IMF refrained from adding any currencies to the SDR in a review at the end of last year, and another formal review of the SDR basket is not due until 2015.
Developed world policymakers, meantime, have said that a currency should be freely floating before it can be included in the SDR. That would seem to exclude many pegged or highly managed emerging market currencies for the foreseeable future.
But there could be loopholes on both of these issues.
For one, although the SDR is currently only used between members of the IMF to support international reserves, the IMF has proposed the idea of tradeable SDR bonds or other SDR-backed assets. This could allow for limited convertibility.
"Whether currencies are fully convertible does not really matter if they are used in an internal SDR," said Ousmene Mandeng, head of public sector investment advisory at fund manager Ashmore Investment Management.
There could also be ways to allow central banks to buy currencies, which may normally be subject to stricter controls.
This has a precedent, of sorts, with the Deutsche mark.
Although the Deutsche mark became fully convertible in 1958, non-residents paid higher tax on government bonds until 1984.
"The general assumption and anecdotal evidence is that when central banks wanted to go into German government bonds, they were exempted from paying these taxes," said Mandeng.
In addition, the IMF does not have to wait until 2015 if it wants to review the constituents of the SDR, IMF watchers say, but could choose to do so at any time.
While SDRs only make up about 4 percent of total global reserves of $9.3 trillion, reserve allocations reflect the composition of the SDR. Currently only 4 percent of total identifiable $5.1 trillion reserves are "other" -- likely to be mainly Swiss francs, Canadian and Australian dollars -- with the SDR composition currencies making up the rest.
While most market participants assume that convertibility of China's yuan is some years off, that time-frame has been shortening. The yuan has gradually grown more accessible and there have been signs of Asian central banks showing an interest in buying yuan-denominated bonds.
"The yuan is becoming a more international currency. It's being used more frequently for trade and investment purposes. It's getting easier to access it and invest in it," said Brian Jackson, senior emerging markets strategist at RBC in Hong Kong.
"People might be prepared to hold it in the hope of it being officially classed as an SDR currency."
The yuan CNY=CFXS has gained 5 percent since it was depegged from the dollar in June 2010. Analysts see further strengthening in the next six months ASIAPOSN.
There have also been some positive noises within the IMF.
The IMF has made several allocations of SDRs into international reserves, most recently in 2009 to help shore up the global financial system.
In a policy paper published this year on the role of the SDR, the Fund said expanding the SDR basket to include major emerging market currencies could cut the costs of international reserve accumulation and reduce exchange rate volatility.
"The basket could smoothly accommodate a greater role for emerging market currencies...notably the renminbi," the paper said.
"Adding a large number of emerging market currencies...seems undesirable, but there may be a case for the ones with the largest weights in global trade and economic growth."
The paper also added that it was unclear that currencies "should await full convertibility to be allowed into the basket".
But lack of depth in capital markets may not follow convertibility quickly enough to make emerging market currencies attractive as reserve assets.
"People may be surprised. Yuan convertibility could happen in the next two years, instead of 20 years -- although it may not be two months," said Stephen Jen, managing partner of hedge fund SLJ Macro Partners.
"But you will also have to establish a yield curve. That requires an independent central bank. This will not happen in two years." (Additional reporting by Natsuko Waki)
Trending On Reuters
India's biggest e-commerce firm Flipkart is buying domestic online fashion retailer Jabong from Global Fashion Group for $70 million in cash, the latest consolidation move in the country's e-commerce sector as competition intensifies. Full Article