Interest Arbitrage under Capital Controls: Evidence from Reported Entrepôt Trades

Abstract Capital controls segment the offshore credit market of Chinese renminbi from the onshore market. Using a novel administrative data set, we provide evidence that firms arbitrage the onshore-offshore interest differentials using bank-intermediated “entrepot trades,” which supposedly re-export imports with little or no processing. Onshore-offshore interest differentials drive renminbi inflows from entrepot trades, which strongly predict 1-year-forward outflows to settle bank-issued letters of credit. The patterns and timing of entrepot trade flows are consistent with lending by onshore banks and borrowing from offshore banks through bank-intermediated trade finance. A larger interest differential allows transactions with a lower value to be profitable and induces entry into arbitrages. Our findings suggest that renminbi interest arbitrages are feasible but costly under capital controls.