perceived risk of using the offshore currency, which led offshore investors to reduce renminbi holding These deposits represent a pool of renminbi liquidity in Hong Kong Sar that can be redeployed to support the expansion of offshore financial markets and products. The pool remained significantly larger than the stock of renminbi financial Figure 4. Renminbi Liquidity Pool in Hong Kong SAR products despite its contraction and, thus, did (RMB bn) not constrain their growth. But, going 000 Share of renminbi deposits(incl. CDs) in HK forward, offshore renminbi liquidity will need to expand in parallel with assets to Corporate customers 600■ Personal ensure progress in renminbi internationalization. In theory, the pool will be replenished by flows of onshore renminbi 20 into offshore renminbi deposits in response o LImIT to market incentives for arbitrage. However, Jul Jan Jul Jan the scale of these flows and hence the 0092010 potential for arbitrage, are constrained by Source: HKMA capital controls. This suggests that an analysis of the effectiveness of arbitrage can shed light on how these controls are limiting progress in renminbi internationalization I. ASSESSING RENMINBI INTERNATIONALIZATION BY ANALYZING ARBITRAGE A. Defining progress in renminbi internationalization Progress in internationalizing the renminbi can be evaluated based on how well the offshore market functions as a substitute for the onshore market To tell whether the two markets are integrated, we assess whether there are no unexploited arbitrage opportunities between them This will be the case when the difference between the cny and cnh exchange rates with the dollar(the basis")is small enough to remain in a"no-arbitrage band, within which arbitrage is not profitable owing to transaction costs such as the bid-ask spread. A metric of the integration of the offshore and onshore markets can be derived by estimating no-arbitrage band and then assessing the extent that the CNY-CNH basis stays within this 9 Estimation shows that the no-arbitrage band is quite wide. Moreover, the basis is outside the band for extended periods, indicating that the offshore renminbi is an imperfect substitute for the onshore renminbi. The differential is often large, indicating that investors and firms face ignificant basis risk the risk that by using CNH in place of CNY could incur significant losses owing to volatility in the basis. An increase in the perceived basis risk makes investors and firms more reluctant to use CNH as a substitute for the CNY, holding back development of an international role for the renminbi They either try to use the cny itself--which is difficult due to capital controls- or the dollar where risks can be better hedge5 perceived risk of using the offshore currency, which led offshore investors to reduce renminbi holding. These deposits represent a pool of renminbi liquidity in Hong Kong SAR that can be redeployed to support the expansion of offshore financial markets and products. The pool remained significantly larger than the stock of renminbi financial products despite its contraction and, thus, did not constrain their growth. But, going forward, offshore renminbi liquidity will need to expand in parallel with assets to ensure progress in renminbi internationalization. In theory, the pool will be replenished by flows of onshore renminbi into offshore renminbi deposits in response to market incentives for arbitrage. However, the scale of these flows and, hence, the potential for arbitrage, are constrained by capital controls. This suggests that an analysis of the effectiveness of arbitrage can shed light on how these controls are limiting progress in renminbi internationalization. III. ASSESSING RENMINBI INTERNATIONALIZATION BY ANALYZING ARBITRAGE A. Defining Progress in Renminbi Internationalization Progress in internationalizing the renminbi can be evaluated based on how well the offshore market functions as a substitute for the onshore market. To tell whether the two markets are integrated, we assess whether there are no unexploited arbitrage opportunities between them. This will be the case when the difference between the CNY and CNH exchange rates with the dollar (the “basis”) is small enough to remain in a “no-arbitrage” band, within which arbitrage is not profitable owing to transaction costs such as the bid-ask spread. A metric of the integration of the offshore and onshore markets can be derived by estimating a no-arbitrage band and then assessing the extent that the CNY-CNH basis stays within this band. Estimation shows that the no-arbitrage band is quite wide. Moreover, the basis is outside the band for extended periods, indicating that the offshore renminbi is an imperfect substitute for the onshore renminbi. The differential is often large, indicating that investors and firms face significant “basis risk:” the risk that by using CNH in place of CNY could incur significant losses owing to volatility in the basis. An increase in the perceived basis risk makes investors and firms more reluctant to use CNH as a substitute for the CNY, holding back development of an international role for the renminbi. They either try to use the CNY itself—which is difficult due to capital controls—or the dollar where risks can be better hedged. Figure 4. Renminbi Liquidity Pool in Hong Kong SAR 0 2 4 6 8 10 12 14 0 100 200 300 400 500 600 700 800 900 1000 Jul Jan Jul Jan Jul Jan Jul Jan (RMB bn) Certificate of deposits Corporate customers Personal customers 2009 2010 2011 2012 2009 2010 2011 2012 2013 (%) Share of renminbi deposits (incl. CDs) in HK total deposits (right scale) Source: HKMA