The Impossible Trinity
But why does it have to be so complicated? Why bother to establish offshore RMB hubs? Wouldn't it be more feasible simply to remove the capital controls? The answer to these questions can be traced back to what economists have dubbed "The Impossible Trinity". Ideally a country's central bank would like to be able to (1) fix a country's exchange rate, (2) allow a free capital flow, and (3) lead an independent monetary policy. However, in praxis this is hardly possible and the central bank will have to forfeit one of these three items. While countries such as the United Kingdom and United States of America largely have relinquished their exchange rate controls to maintain free movement of capital and an autonomous monetary policy, the Chinese government chose to sacrifice the free cross-border flow of capital to keep a fixed exchange rate and control money supply.
The Impossible Trinity also highlights the connection between China's recent moves to lessen capital controls while expanding the daily trading band of the RMB. China may be at a point where it needs to let capital flow more freely in order to facilitate a more efficient distribution. A prime example in this regard is the country's overheated real estate market, where considerable amounts of Chinese have put their savings due to the lack of alternative investment options. Allowing Chinese companies and individuals to invest more freely abroad could not only help China to deflate some of the domestic asset bubbles, but could also deliver some of the much needed capital for struggling western economies like the ones of Europe.
Furthermore, if Chinese investors and enterprises were less constrained with regards to outbound investments, the People's Bank of China - China's central bank - would be less dependent on buying US treasury bonds and could thereby more easily diversify its holdings into other asset classes. The extra outbound investments would most likely cause the RMB to depreciate against the Dollar. In fact, this process may already have begun, as China's stock of outbound investments continues to increase while its foreign exchange reserves slowly are starting to decline. This development has so far been accompanied by two percent depreciation of the USD/RMB exchange rate since the beginning of May 2012.
China may have a long way to go before it can claim a truly international currency. Meanwhile, the primary obstacles to convertibility are associated with capital accounts restrictions and lack of access to the Chinese capital markets. The ability to raise capital and hedge risk is consequently restricted.Caijing.com.cn
Chinese Currency Controls and the Liberalization of the Renminbi
Jens Petersen,China Briefing