Policy Article

RMB Internationalization and the Role of Shanghai Free Trade Zone

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  • Wan-Hsin Liu
  • Yuanfang Li
Publication Date

The government of the People’s Republic of China (China, hereafter) is widely perceived to play an active role in designing and maneuvering the proces

Kiel Institute Expert

The goals are to facilitate China in getting out of the dollar trap, to reduce FX risks and associated costs weighing on the trade sector, and to increase its own stake and influence in the global financial system. Although the term of “RMB internationalization” has never been directly used in China’s official documents, the Chinese government has actively promoted the use of RMB step by step, first in cross-border trade, then in  foreign and outward direct investment (FDI and ODI), and lastly in foreign portfolio investment and bank lending, to different extents. These policy moves have echoed the urge for currency diversification, when the deficiencies in the current international monetary system and the FX risk facing China’s foreign assets became apparent during the recent global financial crisis.

From 2009, RMB internationalization has proceeded rapidly with fast-growing cross-border RMB trade settlements and offshore RMB businesses. RMB is now the fifth most widely used currency according to SWIFT. It climbed up to 2.17 percent of global payments in Dec. 2014 from less than 0.1 percent before 2010. China’s cross-border RMB settlements soared up to 5.2 trillion yuan in 2013 from a merely 3.5 billion in 2009. For 2014 (The data covers the first three quarters of 2014), 22 percent of foreign trade, 31 percent of FDI flows and 16 percent of China’s ODI flows were settled in RMB. (Before 2009 RMB was only used sparsely in cross-border trade.) Offshore deposits in RMB have grown from 54 billion yuan at the beginning of 2009 to 1.56 trillion by mid-2014. Although RMB still accounted for a rather small share in the world’s total reserves and market assets, its development over the past few years has been also impressive, with a number of central banks and sovereign funds claiming holding of RMB assets (Central banks in United Kingdom, Australia, Russia, Japan, Chile, Malaysia, and Nigeria, alongside some of the largest sovereign wealth funds from, for example, Singapore, Norway, Kuwait, Qatar, Abu Dhabi, and Azerbaijan have publicly confirmed holding of or the plan to hold RMB assets), and annual offshore bond issuance in RMB expanding 17.5 times over the past five years thanks to the increasing market recognition.

However, compared to other major currencies including some currencies of emerging economies, RMB is still used much less proportionately considering its weight in the global economy: China’s GDP and trade accounted for 12 percent and 11 percent of the world’s total in 2013 respectively, but the RMB share in global payments value was still less than 2 percent in 2014. Considering the catch-up effects, the momentum for increasing usage of RMB internationally will likely persist if China can maintain stronger growth compared to other major economies and financial stability while deepening its financial reform.

Despite the progress made in the past few years and the bright outlook in the long term, the intrinsic problems with RMB internationalization are also becoming more and more acute at the current stage. The crucial visible impediment is China’s capital account control. Although China has removed almost all restrictions on FDI and then ODI, and even allowed portfolio flows on a quota basis (albeit very limited), restrictions are still quite binding with regard to money market transactions and financial derivatives. In fact, RMB internationalization has accelerated capital account liberalization in China in terms of bringing out a series of policies to establish a “recycling mechanism” for offshore RMB. However, RMB is still far from being a convenient currency for foreign holders facing various restrictions on access to China’s financial market.

Capital account liberalization has been committed as a policy goal by the Chinese government (it was confirmed during the 18th Party Congress in 2013), but there are lots of concerns and disputes regarding the right path and the right timing. (See Gallagher et al. (2014) for a very thorough discussion on capital account liberalization in China.) In theory, capital account liberalization can facilitate financial resource allocation and risk sharing globally. But experiences of lots of emerging economies suggest a link between capital account liberalization and incidence of financial crisis, and not so much a link between it and economic growth. (Reinhart and Rogoff (2009) have examined this issue in details.) According to lots of existing economics literature, the benefits of capital account liberalization can be only realized when proper institutions and policy framework are well anchored in the economy. In view of the “trilemma” literature, when capital account has been liberalized, either the country loses control over exchange rate or over monetary policy, both causing a loss in policy independence. In addition, the related sequencing literature shows that some necessary conditions are prerequisites for capital account liberalization, such as exchange rate flexibility, domestic financial reform including interest rate liberalization and development of domestic financial institutions, markets and instruments, as well as adequate prudential regulation and supervision.

Despite the Chinese government’s willingness and decision for further encouraging RMB internationalization, such necessary conditions as mentioned above are, however, not easily realizable. On the one hand, China is relatively inexperienced in related institutional reforms in this regard. On the other hand, given China’s high heterogeneity in economic development and international exposure of different regions and industries, it is difficult to predict the extent to which such reforms may have impact on domestic economic stability. Against this background the Chinese government launched Shanghai Free Trade Area (Shanghai FTA, hereafter) with focus on service sectors in September, 2013 as a pilot experiment platform to test a broad spectrum of reform policies including RMB interest rate liberalization, facilitating cross-border financing and financial investments, opening financial services sectors, and innovating the regulatory framework. All these policies are expected to support the realization of capital account convertibility and more progress in RMB internationalization in the pilot Shanghai FTA. The Chinese government’s decision to carry out the experiment policies in a specific area in Shanghai is motivated by Shanghai’s key role in China’s financial market as well as the government’s ambition to support Shanghai’s development to become an international financial center. Restricting the validity of the policies in a restricted area makes it easier for the Chinese government to supervise the implementation and the impacts of the planned policies and to better monitor and control any possible spillover effects of the policies to other regions. The successful policy experiments within the Shanghai FTA should be rolled out to the other best-conditioned Chinese regions or even to the whole China later.

A series of policy documents have been released since 2013 to build up the necessary institutional and policy framework for a functional Shanghai FTA. While the State Council sets up the goal of Shanghai FTA, including the acceleration of the policy experiments on capital account and full liberalization of the financial services industry in the next 2–3 years, other regulatory bodies develop more detailed policy framework under which the financial institutions, non-financial enterprises and individuals operate. Despite the policy attempts announced by some of the regulatory bodies, such as China Banking Regulatory Commission and China Securities Regulatory Commission, more concrete working rules derived from the policy attempts are still missing. One exception here is the People’s Bank of China (PBC) which already released more detailed working rules concerning the free trade account system, expanding the usage of RMB in cross-border settlements and foreign exchange administration in 2014. Due to the missing working rules and time lags between the just implemented rules and regulations and their impact, the potential progress that could otherwise be made in services trade, finance and investment liberalization in the Shanghai FTA to back RMB internationalization is rather restricted.

Still, implementing the first experiment policies and working rules in the Shanghai FTA has created new opportunities for encouraging RMB internationalization in the following three ways. First, cross-border settlements in RMB under current account and direct investment are greatly simplified. The banks involved are allowed to engage in such settlements as long as they “know the customers”, “know their businesses”, and conduct with “due diligence”. Second, cross-border settlements in RMB are now expanded to cover individuals’ businesses operated in Shanghai FTA as well. Third, the Shanghai FTA is legally opened to some new types of businesses in RMB such as borrowing RMB from overseas by financial institutions and enterprises, centralized cross-border settlements in RMB for affiliated enterprises and cross-border payment in RMB for e-commerce.

These new opportunities in the Shanghai FTA to encourage RMB internationalization are accompanied with some challenges. For example, the RMB backflow mechanisms for the transactions in the Shanghai FTA are still limited. For example, the Shanghai-Hong Kong stock link, as an import move in opening cross-border securities investment in RMB, particularly in opening Shanghai stock market to broad-based overseas investors, has already been put into practice. But it is under strict quota management on a daily and yearly basis. RMB borrowing has also been permitted for companies registered in Shanghai FTZ, but the borrowing period, the usage and the amount have all been strictly regulated. The limited backflow mechanisms need to be adjusted and expanded accordingly. Second, if the regulation of interest rate and exchange rate persists in other regions in China outside the Shanghai FTA, while the financial flows in the latter are gradually integrated into the world market, Shanghai FTA may become an ideal place for oversized financial speculations, thus a critical source of macroeconomic instability in China and an impediment for its sustainable growth in the future. Especially the second challenge is not expected to be solved in the near future, before the experiment policies in the Shanghai FTA are proved to achieve the expected impacts with limited or affordable economic and societal costs and thus can be applied in other regions in China as well. And this is difficult to be realized against the background that some detailed working rules for encouraging capital account convertibility and RMB internationalization in the Shanghai FTA are still missing as mentioned above. In other words, it is still a long way to go for the Chinese government to design and implement all policies and more detailed rules and regulations needed firstly in the Shanghai FTA and apply the successful ones further to the whole China, thus being able to make promising progress in RMB internationalization in the next decades.


Gallagher, Kevin P., José Antonio Ocampo, Ming Zhang, Yongding Yu (2014). Capital Account Liberalization in China: The Need for a Balanced Approach. Pardee Center Task Force Report/October 2014, Boston University.

Reinhart, Carmen, and Kenneth Rogoff (2009). This Time Is Different: Eight Centuries of Financial Folly. Princeton: Princeton University Press.

(This article is a revised and extended summary based on ‘Li (2014), Shanghai FTZ in the Process of RMB Internationalization: A Chinese Perspective on the Macroeconomic and Financial Implications’, included in the project report entitled “The development of the RMB offshore market and the liberalization of China’s capital account”, co-funded by British Academy and Chinese Academy of Social Sciences.)