amounting to 2.6 trillion yuan and accounting for some 10 per cent of China’s total trade settlement as of late-2012. This is quite a remarkable achievement.

The experience since the launch of RMB trade settlement schemes in 2009 shows that exchange rate arbitrage and interest rate arbitrage are the two key drivers for the progress of RMB internationalisation.

RMB import settlements enabled the RMB to flow into Hong Kong, which established a Hong Kong-based RMB pool. While the RMB exchange rate in Hong Kong, dubbed CNH, is decided by market forces, the rate in the mainland, dubbed CNY, is subject to constant intervention by the People’s Bank of China. As a result, two exchange rates coexist for the RMB. Whenever the RMB is under pressure to appreciate, the CNH-CNY spread increases, importers in the mainland purchase the US dollar in Hong Kong to pay their imports, and RMB liquidity flows into Hong Kong. Owing to appreciation expectations and the opportunities for investment in RMB-denominated assets in the mainland that have higher returns, RMB deposits and bond issuance in Hong Kong have increased correspondingly.

However, since late 2011, due to China’s shrinking current account surplus and large fluctuation of cross-border capital flows, the expectation of the RMB’s appreciation has weakened significantly. Due to the narrowing or reversing of the CNH-CNY spread and the remaining capital controls, while Chinese importers became less active in purchasing US dollars in Hong Kong for exchange rate arbitrage, residents in Hong Kong were less eager to hold RMB deposits.

But why have RMB trade settlements continued to increase despite declining opportunities for exchange rate arbitrage? While a contributing factor is the sheer size of China’s trade and the convenience of using the RMB for transaction settlements, an important additional factor is interest rate arbitrage, which has led to a rapid increase in RMB-denominated letters of credit (L/C).

There are many ways of doing interest rate arbitrage through L/C. For example, Enterprise A, a mainland enterprise, can deposit a certain amount of RMB in a mainland bank for one year. Under the RMB import settlement scheme, it can use the RMB deposit as collateral to obtain a RMB-denominated L/C from the mainland bank, and use the L/C to purchase goods from its affiliate — Enterprise B in Hong Kong. Enterprise B in turn can use the L/C as collateral to borrow US dollars from a bank in Hong Kong and use the dollars to buy back the goods it has sold to Enterprise A. Enterprise A then converts the USD into RMB in the spot market and deposits it in its bank in the mainland. When the L/C is settled one year later, Enterprise A pays Enterprise B in RMB via the mainland bank. Finally, Enterprise B converts the RMB into the dollar at the exchange rate, which has already been locked in the NDF (non-deliverable forward) market, and repays the dollar loans extended by the Hong Kong bank. Because the interest rate on RMB deposits is significantly higher than that on dollar loans, Enterprise A and its affiliate Enterprise B obtain material profits from this process.

An unexpected development in RMB internationalisation in recent years is the significant increase in the use of the RMB as a reserve currency by foreign central banks. This is not only a reflection of China’s economic strength but also a result of the weakening status of traditional reserve currencies, particularly the US dollar and euro. This implies that efforts to expand the use of the RMB will also be influenced by changes in preference for the US dollar. The more political wrangles in Washington erode economic confidence, the more scope the RMB has to make inroads in becoming an international reserve currency.

A fundamental constraint for RMB internationalisation is China’s capital controls. Although the internationalisation of a currency is not tantamount to capital account liberalisation, the degree of internationalisation is conditional on the extent of capital-account liberalisation. China has embarked on the process of capital account liberalisation in a gradual manner since 1996, and the remaining capital controls are mainly used to regulate short-term capital movements.

The question facing the Chinese government at the moment is whether it should abandon such controls. Certainly, in the right circumstances, capital account liberalisation will give an extra boost to RMB internationalisation. But before having made the capital account fully open and the RMB freely convertible, China needs first to put its own house in order. Macroeconomic stability has to be achieved; the high ratio of financial leverage should be reduced; a rational and flexible interest rate structure must be created; risk management capacity across industries should be established; and intervention in the foreign exchange market minimised. Most importantly, China must make the RMB exchange rate flexible to reflect demand for and supply of foreign exchange in the forex market. The litany of tasks required does not end there. And all of this will take time. But without completing these reforms, hasty capital account liberalisation could lead to dire consequences.

My bet is that due to the high risks involved, the Chinese government will maintain a gradualist approach with regard to capital account liberalisation. Hence, RMB internationalisation will continue to enjoy steady progress but there will be no sensational developments. After the capital account has been fully liberalised and RMB dynamics are no longer driven by arbitrage, then the progress of RMB internationalisation — alongside the continuous expansion of the economy — will depend increasingly on the specific nature of Chinese firms, industrial organisation, business models, the type of products traded, and the bargaining power of Chinese firms and their counterparties.

There is no doubt whatsoever that the RMB will become a major international currency, but the internationalisation journey is a long march. China is just at the beginning.

Yu Yongding is former President of the Chinese Society of World Economy and was Director-General of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences.