. NTRODUCTION The development of an international role for the renminbi is tied to Chinese capital account liberalization. The selective easing of mainland capital controls expanded the range of cross b transactions denominated in renminbi and led to rapid growth in offshore renminbi deposits, issuance and lending in Hong Kong SAR. This growth leveled off in 201 1 and has recently resumed at a more modest pace. These developments raise several questions. First, how far advanced is renminbi internationalization? This question can be addressed by assessing how effectively the offshore currency is functioning as a substitute for the onshore currency. Second, how has capital account liberalization supported the offshore use of the renminbi? And, third, how can this progress be sustained? The next section examines the expansion in the offshore role of the renminbi, highlighting the uneven process across different uses of the offshore currency. Section Ill assesses progress in enminbi internationalization by estimating the integration of offshore and onshore renminbi markets. Specifically, a Threshold Autoregression(TAR) model is applied to daily data to test whether differential between the offshore exchange rate(the CNh)and the onshore exchange rate (the CNy) involves unexploited arbitrage opportunities and finds that this is the case. This likely reflects the limits on arbitrage from capital controls together with other factors. a VAR model is applied to monthly data to identify these factors and finds that shifts in global market sentiment plays a key role along with capital controls. Section IV examines how Chinese liberalization measures have promoted offshore use of the renminbi in Hong Kong SAR Controls on capita inflows have been eased more than on outflows, suggesting that, going forward, more balanced liberalization measures would help sustain progress in renminbi internationalization I. DEVELOPMENT OF THE OFFSHORE RENMINBI MARKET China is seeking to promote the international use of its currency while maintaining capital controls through the development of offshore markets for the renminbi. The offshore renminbi was established in 2003, with the creation of an offshore settlement infrastructure and personal renminbi banking services in Hong Kong SAR. Efforts to develop offshore renminbi financial products and services accelerated in 2009 as the global financial crisis exposed the fragil ities of the dollar-based international financial system Figure 1. Renminbi Cross-Border Trade Settlement Promotion of an international role of the renminbi (RMB bn) initially focused on trade settlement. This started 1000 with a pilot scheme for cross-border trade settlement 900 Service trade(left axis) Goods trade(left axis) in renminbi in 2009 that had expanded to all Share of goods mainland exporters and importers by 2012. This 600F trade settled in reflected the practical objective of allowing more goods trad Chinese corporates to conduct cross-border trade their own currency to eliminate the currency risk The effort met with considerable success as the share of mainland goods trade denominated in renminbi 2012 2013 33 I. INTRODUCTION The development of an international role for the renminbi is tied to Chinese capital account liberalization. The selective easing of mainland capital controls expanded the range of cross border transactions denominated in renminbi and led to rapid growth in offshore renminbi deposits, bond issuance and lending in Hong Kong SAR. This growth leveled off in 2011 and has recently resumed at a more modest pace. These developments raise several questions. First, how far advanced is renminbi internationalization? This question can be addressed by assessing how effectively the offshore currency is functioning as a substitute for the onshore currency. Second, how has capital account liberalization supported the offshore use of the renminbi? And, third, how can this progress be sustained? The next section examines the expansion in the offshore role of the renminbi, highlighting the uneven process across different uses of the offshore currency. Section III assesses progress in renminbi internationalization by estimating the integration of offshore and onshore renminbi markets. Specifically, a Threshold Autoregression (TAR) model is applied to daily data to test whether differential between the offshore exchange rate (the CNH) and the onshore exchange rate (the CNY) involves unexploited arbitrage opportunities and finds that this is the case. This likely reflects the limits on arbitrage from capital controls together with other factors. A VAR model is applied to monthly data to identify these factors and finds that shifts in global market sentiment plays a key role along with capital controls. Section IV examines how Chinese liberalization measures have promoted offshore use of the renminbi in Hong Kong SAR. Controls on capital inflows have been eased more than on outflows, suggesting that, going forward, more balanced liberalization measures would help sustain progress in renminbi internationalization. II. DEVELOPMENT OF THE OFFSHORE RENMINBI MARKET China is seeking to promote the international use of its currency while maintaining capital controls through the development of offshore markets for the renminbi. The offshore renminbi was established in 2003, with the creation of an offshore settlement infrastructure and personal renminbi banking services in Hong Kong SAR. Efforts to develop offshore renminbi financial products and services accelerated in 2009 as the global financial crisis exposed the fragilities of the dollar-based international financial system. Promotion of an international role of the renminbi initially focused on trade settlement. This started with a pilot scheme for cross-border trade settlement in renminbi in 2009 that had expanded to all mainland exporters and importers by 2012. This reflected the practical objective of allowing more Chinese corporates to conduct cross-border trade in their own currency to eliminate the currency risk. The effort met with considerable success as the share of mainland goods trade denominated in renminbi Figure 1. Renminbi Cross-Border Trade Settlement 0 2 4 6 8 10 12 14 16 18 0 100 200 300 400 500 600 700 800 900 1,000 2010 2011 2012 2013 Service trade (left axis) Goods trade (left axis) (RMB bn) (%) Share of goods trade settled in RMB in total goods trade Source: People’s Bank of China