Modelling RMB internationalization and impact on capital flow

China began its economic reforms in the end of the 1970s, which have successfully transformed the country into an important trading nation and manufacturing centre in the world over the past three decades. Despite China’s recent economic slowdown, the IMF forecasts that China will continue to be the largest contributor to global GDP growth. In addition, the rate of return for holding RMB over the past ten years has been one of the highest, which explains the strong portfolio capital inflows since 2004. Probably the only remaining issue is about China’s capital control, especially over the flows of portfolio investment. The progress of RMB internationalization helps facilitate the short term capital flows, and is believed to have a new interactive effects on the exchange rate expectation and capital flows nexus. This paper intends to employ the asset portfolio balance model to explore the effect of RMB exchange rate expectation on RMB internationalization. In particular, we empirically explore the relationship between RMB exchange rate expectation, RMB internationalization and short-term capital flow by using SVAR model and the monthly data from February 2004 to November 2014. The results indicates that RMB exchange rate appreciation could increase the demand of foreign investors for RMB and RMB denominated bonds and vice versa, and also attract short-term capital inflow through reducing the capital flow cost. This paper implies that, associated with the rapid RMB internationalization, the central bank needs to pay more attention to the short term capital flow as its destabilizing effect may cause panic to the financial syste