A Chinese Trilemma: Renminbi Internationalization, Capital Account Opening, and Domestic financial liberalization By arthur Kroeber Arthur Kroeber is managing director of Gavekal Dragonomics, an economic research firm with offices in Hong Kong and Beijing, and editor of the China economic quarterly Since 2009 Chinese authorities have indicated, in policy actions, research documents and speeches, a general intention to pursue financial sector reform through three main channels internationalization of China's currency, the renminbi; gradual opening of the capital account and liberalization of domestic interest rates yet the reforms in all three areas have been fitful and intermittent, and more important the government has not communicated a clear vision of how these reforms will be sequenced. It is generally recognized that a failure to properly sequence financial reforms can have severe and even disastrous consequences. It is hard to square the apparently high priority given to financial reforms with their apparently incoherent mplementation. I will argue that this contradiction arises not from a flawed strategy but from the efforts of reformers to push ahead financial liberalization in an opportunistic way in the face of strong political opposition and bureaucratic fragmentation RMB internationalization: stalking horse for domestic financial reform? In a developing economy with heavily regulated domestic interest rates, capital controls and a non-convertible currency, a normal sequence of financial liberalization would be to deregulate domestic interest rates first, liberalize the capital account next, and finally (and optionally push ahead the international use of one's currency for trade invoicing and debt issuance. (In earlier eras developing countries were often encouraged to lift capital controls at a relatively early stage but a sequence of emerging-market financial crises in the 1990s, culminating with the Asian Financial Crisis of 1997-98, demonstrated the folly of premature capital-account opening. The IMF, once the strongest institutional advocate of open capital accounts, now accepts the usefulness of capital controls in emerging economies. China, uniquely, reversed this conventional order by launching an ambitious currency internationalization program in 2009 despite maintaining draconian capital controls and heavily regulated domestic interest rates. The RMB internationalization drive mainly involved permitting banks in Hong Kong to offer rMB deposit accounts, encouraging the invoicing and settlement of China's foreign trade in RMB, and creating markets for the issuance of RMB-denominated bonds, initially in Hong Kong and later in other jurisdictions including Singapore and London At around the same time, the People's Bank of China(PBC)signed a number of swap The IMF's new conditional acceptance of the usefulness of capital controls is in Staff Position Note-Capital Inflows: The Role of Controls, SPN/10/04, 19 February, 2010. This reverses a stance from five years earlier deploring their use: International Monetary Fund, Independent Evaluation Office, Report on the Evaluation of the IMF's Approach to Capital Account Liberalization", SM/05/142, Chapter 2, 20 April, 2005A Chinese Trilemma: Renminbi Internationalization, Capital Account Opening, and Domestic Financial Liberalization By Arthur Kroeber Arthur Kroeber is managing director of Gavekal Dragonomics, an economic research firm with offices in Hong Kong and Beijing, and editor of the China Economic Quarterly. Since 2009 Chinese authorities have indicated, in policy actions, research documents and speeches, a general intention to pursue financial sector reform through three main channels: internationalization of China’s currency, the renminbi; gradual opening of the capital account; and liberalization of domestic interest rates. Yet the reforms in all three areas have been fitful and intermittent, and more important the government has not communicated a clear vision of how these reforms will be sequenced. It is generally recognized that a failure to properly sequence financial reforms can have severe and even disastrous consequences. It is hard to square the apparently high priority given to financial reforms with their apparently incoherent implementation. I will argue that this contradiction arises not from a flawed strategy but from the efforts of reformers to push ahead financial liberalization in an opportunistic way in the face of strong political opposition and bureaucratic fragmentation. RMB internationalization: stalking horse for domestic financial reform? In a developing economy with heavily regulated domestic interest rates, capital controls and a non-convertible currency, a normal sequence of financial liberalization would be to deregulate domestic interest rates first, liberalize the capital account next, and finally (and optionally) push ahead the international use of one’s currency for trade invoicing and debt issuance. (In earlier eras developing countries were often encouraged to lift capital controls at a relatively early stage, but a sequence of emerging-market financial crises in the 1990s, culminating with the Asian Financial Crisis of 1997-98, demonstrated the folly of premature capital-account opening. The IMF, once the strongest institutional advocate of open capital accounts, now accepts the usefulness of capital controls in emerging economies. 1 ) China, uniquely, reversed this conventional order by launching an ambitious currency￾internationalization program in 2009 despite maintaining draconian capital controls and heavily regulated domestic interest rates. The RMB internationalization drive mainly involved permitting banks in Hong Kong to offer RMB deposit accounts, encouraging the invoicing and settlement of China’s foreign trade in RMB, and creating markets for the issuance of RMB-denominated bonds, initially in Hong Kong and later in other jurisdictions including Singapore and London. At around the same time, the People’s Bank of China (PBC) signed a number of swap 1 The IMF’s new conditional acceptance of the usefulness of capital controls is in Staff Position Note – Capital Inflows: The Role of Controls”, SPN/10/04, 19 February, 2010. This reverses a stance from five years earlier deploring their use: International Monetary Fund, Independent Evaluation Office, “Report on the Evaluation of the IMF’s Approach to Capital Account Liberalization”, SM/05/142, Chapter 2, 20 April, 2005