January 13, 2020
China’s launch of a central bank digital currency seems to be drawing near. That the world’s second largest economy is about to launch a blockchain-based digital currency is certainly momentous. I’m very curious to learn its technical design, especially to understand how it accomplishes offline payments and “controllable anonymity.” My guess is that it will be a digicash-like design. That said, I keep hearing in the media, in official pronouncements, and in conversation that China’s digital yuan will pose a threat to the dollar. On that score I am not convinced.
So what’s the threat? Last year two members of Congress wrote to Fed Chair Jay Powell, “We are concerned that the primacy of the U.S. Dollar could be in long-term jeopardy from wide adoption of digital fiat currencies,” namely China’s. In a Wall Street Journal oped, former CFTC Chair Christopher Giancarlo and Dan Gorfine wrote that like the Soviets launching into space threatened U.S. technological dominance, “recent developments in digital currencies similarly threaten the dollar’s dominance” and that “a network of Beijing-dependent states trading a digital yuan … could end the delicate world economic order Americans have long taken for granted.”
Maybe I’m not clear on what threat exactly folks see from the digitization of the yuan, but it certainly isn’t going to affect the dollar’s status as the dominant global reserve currency. That’s because the yuan’s fundamentals make it unsuited to be a major global reserve currency. Indeed it accounts for less than 2 percent of global reserves, compared to the dollar’s 60 percent. If central banks wanted to hold the yuan today, they would, but they don’t. That it will soon have a digital version available won’t change its fundamentals or central bank demand for it. It will still be the yuan.
Global reserve currencies like the dollar, euro, yen, and pound sterling have certain essential characteristics that the yuan lacks. There are many, but just a couple of important ones are a freely floating exchange rate, as well as backing by a country with macroeconomic stability, a good regulatory regime, a commitment to the rule of law, and deep, liquid, and transparent markets. China and the yuan score poorly on these counts. George Magnus summarizes it succinctly in Red Flags: Why Xi’s China Is in Jeopardy:
”First, and foremost, there is only one way to have a significant global currency, which is to allow foreigners to acquire and accumulate claims on you. In other words, just as the US has allowed foreigners to build up holdings of US bonds and other US assets (which are America’s liabilities), so China would have to as well. There are, though, only two ways this can happen. One is by running current account deficits, so that foreigners receive more of your currency than they pay for goods and services. The other is by having an open capital account, so that capital flows freely abroad. China runs a current account surplus, smaller than it used to be, but structurally entrenched for the time being. To balance this surplus, capital has to flow out but it is subject to controls that keep it locked up at home. The likelihood of China running current account deficits or allowing a meaningful liberalisation of capital account transactions any time soon is negligible. If anything, the surplus is likely to increase again as growth slows in the future. Consequently, the Renminbi is strongly handicapped when it comes to becoming a more serious global reserve currency. It is still possible for businesses and commercial organisations to use the Renminbi more for transactions in the future but that is quite different from becoming a more important global reserve currency.
And that doesn’t even mention China’s weak institutions, the state’s track record of intervening in markets, and most importantly “the fragility of the Chinese economy and especially the tremendous systemic risk, bad debt and other problems that plague China’s financial sector.” On that I recommend China’s Great Wall of Debt: Shadow Banks, Ghost Cities, Massive Loans, and the End of the Chinese Miracle by Dinny McMahon.
Given all this, it’s clear the yuan is at the very least decades away from challenging the dollar as a global currency, and again, a digital yuan is still the yuan. (Of course, like the pound sterling before it, the U.S. dollar could decline for its own reasons and open itself to challenge from the yuan and other currencies, but that’s separate from what China can do today proactively to challenge the dollar.)
So if the digital yuan is not a threat to the dollar’s global reserve currency status, could it instead threaten the dollar’s dominance in international payments and replace SWIFT? Perhaps marginally the yuan’s digitization would make it easier to use in global trade, but such use is still tied to reserve currency status. China’s efforts to internationalize the yuan, including launching its own Cross-Border Interbank Payment System in 2015 as an alternative to SWIFT, have so far borne little fruit.
When I make this point I’m often told that China, especially through its Belt and Road Initiative, has power over many emerging economies in Africa, Asia, and Latin America, and it could essentially require them to adopt the yuan. But as the FT points out, that’s just not the case:
When China first unveiled its plans to connect more than 65 countries along a modern Silk Road in 2013, the project was met with great fanfare. The Belt and Road Initiative (BRI), as it was later renamed, was initially hailed as “the most ambitious economic and diplomatic program since the founding of the People’s Republic”. Beyond the pledge that it would help to turn China into a high-income economic powerhouse, Chinese officials also touted the BRI as a vehicle for transforming the country’s currency into a global one.
Five years on, the renminbi hasn’t made much headway as an internationally-recognised unit of account, medium of exchange or store of value — the three functions a global currency must fulfill. In fact, the majority of BRI projects are not even funded this way. Like most global transactions, the dollar dominates, putting a natural cap on just how revolutionary the BRI can be. …
In August 2015, the renminbi stood as the world’s fifth most-active currency for domestic and international payments, with a 2.8 per cent share according to SWIFT. By 2016, it had slipped a slot to 1.67 per cent. As of October, it remains in sixth place, with a 1.70 per cent share. The dollar, on the other hand, has maintained its commanding share of domestic and international payments at roughly 40 per cent: Even in China, the use of the renminbi to settle trade has declined. Today, just 13 per cent is renminbi-denominated. Three years ago, it was about double that.
So if the digitization of the yuan will likely have only a small marginal effect on its internationalization, why is the Chinese government doing it? As naive as it might seem, one place to start in answering this question is to listen to what China says is its motivation.
Here is Mu Changchun, the head of the People’s Bank of China’s digital currency initiative quoted in September: “Why is the central bank still doing such a digital currency today when electronic payment methods are so developed? It is to protect our monetary sovereignty and legal currency status. We need to plan ahead for a rainy day.” What rainy day? Here is Mu quoted in October: “If Libra is accepted by everyone and becomes a widely used payment tool, then after some time, it is entirely possible that it will develop into a global, super-sovereign currency. We need to plan ahead to protect our monetary sovereignty.”
So in reality, the digital yuan may be a mostly defensive, and not offensive, move. (And I don’t mean about Libra specifically, but about monetary sovereignty generally.)
Of course, there are other reasons why the initiative would be attractive to the state. For one thing, it fits in with China’s continuing efforts to limit the use of physical cash. As described by officials, the digital yuan will only replace cash (M0) not bank deposits (M1 or M2). That in turn will allow the government to stop counterfeiting (a big problem in China) and better surveil and have control over financial transactions. Again, I look forward to seeing how the “controllable anonymity” planned for the digital yuan will work technically.
Finally, for what it’s worth, Kenneth Rogoff thinks that while the digital yuan won’t supplant the dollar, it could compete in the market for illicit transactions:
Control over the underground economy, however, is another matter entirely. The global underground economy, consisting mainly of tax evasion and criminal activities, but also terrorism, is much smaller than the legal economy (perhaps one-fifth the size), but it is still highly consequential. The issue here is not so much whose currency is dominant, but how to minimize adverse effects. And a widely used, state-backed Chinese digital currency could certainly have an impact, especially in areas where China’s interests do not coincide with those of the West.
A US-regulated digital currency could in principle be required to be traceable by US authorities, so that if North Korea were to use it to hire Russian nuclear scientists, or Iran were to use it to finance terrorist activity, they would run a high risk of being caught, and potentially even blocked. If, however, the digital currency were run out of China, the US would have far fewer levers to pull. Western regulators could ultimately ban the use of China’s digital currency, but that wouldn’t stop it from being used in large parts of Africa, Latin America, and Asia, which in turn could engender some underground demand even in the US and Europe.
While China’s new digital currency doesn’t really pose a threat to the dollar, it’s not going to be boring either. I look forward to its launch.
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