In Chapter 5, the importance of capital account liberalization is discussed. I explain how the “coalescing effect” and “thick market externalities” effect determine the use of a currency for trade invoicing and denominating financial assets and use the theory to explain why capital account opening, in addition to financial development and the size of the economy, is essential to RMB internationalization. I ask two questions: Given that capital account opening carries risk, should China open its capital account just because it want to internationalize the RMB? Do the benefits of capital account opening outweigh the costs of it regardless of whether China pursues RMB internationalization? To answer these questions, I discuss the benefits and costs of capital account liberalization, including the loss of exchange rate stability due to the open-economy trilemma. I explain the theoretical basis of the trilemma and the empirical evidence for it. I then point out that there is a positive feedback effect between capital account opening and financial market reform. Thus, the initiative to internationalize the RMB, which calls for capital account opening, can set forth a chain reaction that facilitates capital account opening and the financial market in tandem in a gradual and interactive manner.

In Chapter 2, I explain why China desires a stable exchange rate. International trade has been very important to China’s economic development ever since reform and opening started in 1978. China had a huge rural labor surplus (underemployed rural labor force) that had to be absorbed by the economy. Thus, it needed to keep its labor employed by expanding external demand through exporting. In order to sustain export-promotion, during 1996-2005, China had been maintaining a stable and under-valued exchange rate versus the USD. As a result of this exchange rate policy, China rapidly became an important player in international trade. A stable and undervalued exchange rate with the USD has therefore become the cornerstone of China’s initial development strategy. Besides, China has a fear of floating its exchange rate, because of historical experiences, such as the Plaza Accord and the Asian Financial Crisis. In fact, results of academic studies are ambiguous about whether exchange rate management is economically inefficient. The stable exchange rate policy, however, becomes an obstacle in RMB internationalization, which requires that China allows much freer capital mobility. The two cannot be achieved at the same time if autonomy in monetary policy is to be maintained, according to the open-economy trilemma.