China’s answer to Crypto Currencies: Digital Yuan. Monetary policy adapting to fintech era?
Ask yourself: have you used actual physical cash (banknotes or coins) to make any of your recent shopping purchases? Having asked a couple of my close friends and relatives, the overwhelming majority replied either: “No” or “May be once”… Admittedly, COVID-19 pandemic reiterated the importance of electronic payments in today’s increasingly transactional world. With individual households actively shopping online and businesses digitalizing their daily operations, one may wonder: “are there any key financial institutions that are yet to undergo digitalization in their key functions?”
Take, for instance, central banks (such as ECB in the Eurozone or Federal Reserve in the US). The central bank exercises certain powers over the amount of money, disposable within the economy, thereby influencing the country’s future well-being. Think of the crisis in 2008, when the financial sector of the US economy was in a desperate need for liquidity. Federal Reserve came to rescue; a gradual cut in the key interest rate down from 5.25% in early 2007 to 0% in late 2008 stimulated an influx of money into the US economy and ultimately helped restore the investors’ faith and confidence in financial markets.
Fast forward to 2021 and the reality of cashless economy begins catching up with central banks too. In fact, many of the recent research initiatives by the central banks worldwide argue for (or, at the very least, consider) circulation of digital currency (as a direct substitute to traditional currency). Of all countries, China is currently ahead of the rest —a trend not surprising, given that the country is one of the earliest adopters of digital payment systems worldwide (in part thanks to apps like AliPay and WePay).
PBOC (China’s central bank) had initiated a plan for the release of Digital Yuan in 2014, had begun a research initiative in 2017 and did a few basic pilot test roll-outs of the currency in 2020. A bigger scale pilot test has been already planned in a couple of host cities of 2022 Winter Olympics. The e-CNY will function as a direct replacement of Central Bank’s reserve M0 money (being banknote and coin deposits). However how would the fully digital currency world (as opposed to a hybrid world of digital and traditional currency) be beneficial to the well-being of China’s monetary system?
- Digitalized Yuan creates opportunities for the currency’s use in settling cross-border transactions. Considering that People’s Central Bank of China possesses significant monetary power (as compared to most retail and institutional investors), the digitalization of Yuan might play a pivotal role in promoting its status as an international currency. If true, Yuan may, over time, go on to challenge the “global currency” status quo of the US Dollar.
- Digitalized Yuan transactions will happen under the centralized jurisdiction of the People’s Central Bank of China. Digitalizing the Yuan would facilitate for a better governance around the money flow, thus helping to detect fraudulent transactions (which involve anti-money laundering or illegal funds’ solicitation). A valid counterargument to this idea is that the privacy of the users will be significantly undermined. Opposers of the Digital Yuan argue that the true motive behind development of Digital Yuan lies in the ambition of Chinese government to further strengthen control over the life of its own citizens.
- Digitalized Yuan acts as a direct substitute to the traditional physical currency (Yuan banknotes and coins). Digitalizing the Yuan would help reduce the frictions and transaction costs associated with central bank money transfers to and between commercial banks and vice versa. This would in turn improve the money velocity in the economy and reduce the time lag between implementation of monetary policy and monetary policy actually taking effect.
A lot of avid readers might be wondering though: how would Digital Yuan be any different from a regular Crypto currency (such as a Bitcoin or an Ethereum)?
- The Digital Yuan, as of now, is the only legal digital currency in China (Bitcoin tenders are not allowed)
- The value of Digital Yuan will be backed by the value of the Yuan currency itself (whereas Bitcoin is backed by the value of energy). As such, digital Yuan is no different from physical Yuan (except for the payment medium) and is therefore not subject to speculation (unlike the hotly contested Bitcoin)
- The governance and issuance of Digital Yuan will be centralized (by the national banking authorities of China); whereas the governance and issuance of Bitcoin is decentralized (theoretically, any company with access to the right blockchain technologies can mine bitcoins)
- The supply of Digital Yuan money, much like the supply of Yuan itself, is unlimited; the supply of Bitcoin is limited to 21,000,000 units (the number of possible blockchain combinations for mining Bitcoins)
The outbreak of COVID-19 certainly offered a strong momentum for the China’s policymakers to speed up the process of its digital currency rollout. While the idea behind Digital Yuan sounds promising, the process of the currency rollout is gradual and thus far there have been only a few pilot tests of the rollout.
In the end of 2020, the city of Shenzhen issued the digital currency in 50,000 electronic “red envelopes” (the so-called hongbaos, worth 200 yuan each) via a random draw to the registered participants. The digital yuan from the red envelopes were redeemable in shops funding the lottery: Chinese online retail giant JD.com (which became the first online platform to accept digital yuan) and a list of other designated offline shops. A couple other cities in China also engaged in similar company-sponsored lotteries.
The rollout of digital Yuan could be another breakthrough in the world of fintech, however the implementation might prove very problematic. Not only will it take time for the consumers to adapt to this new reality, but it would also be hard to reconcile the concerns amongst many citizens who fear that their privacy might be severely compromised with Digital Yuan’s growing popularity across the nation.
