Central banks worldwide are implementing digital solutions to improve the efficiency of the financial system. Amongst the G20 countries, 19 out of 20 are exploring the idea of a Central Bank Digital Currency (CBDC), with 16 already in the development stage. China appears to be at the forefront of CBDC development with great ambitions to alter the global financial system.
What is a CBDC?
A Central Bank Digital Currency (CBDC) is a digital token which acts as a completely digital version of cash issued and guaranteed by a central bank. CBDCs are unlike cryptocurrencies, which are decentralised and, in the case of stable coins, have values pegged to a fiat currency like the dollar or euro. Central banks worldwide are experimenting with the idea of CBDCs to develop efficient channels for direct monetary and fiscal policy, promoting financial inclusion by improving access to money and establishing competition in domestic markets. The People’s Bank of China (PBoC) has been a forerunner in the CBDC space since
2014, with the development of the digital yuan which places them ahead of several other countries, is still in the research and planning phase. This early development allows China to internationalise the renminbi (RMB) and disrupt the dollar’s hegemony.
Dollar supremacy
The Bretton Woods system which was set up in 1944, paved the way for the US
dollar’s emergence as the world’s international reserve currency. Consequently, global economies and financial markets became interwoven with the dollar and the American economy. Today, though China is the world’s largest trading partner, the RMB still makes up less than
2 percent of the world’s reserve currency. The disparity between trade and currency status in the global economy is a cause for concern for China, which is structurally indebted to a dollar-dominated financial system.
Central banks worldwide are experimenting with the idea of CBDCs to develop efficient channels for direct monetary and fiscal policy, promoting financial inclusion by improving access to money and establishing competition in domestic markets.
With the rapid rise of China’s economic prowess, the continuing clout of the US dollar in the global markets is a cause of concern for the Chinese. The dollar’s supremacy allows the United States (US) to impose sanctions on Chinese companies by detaching them from global payment rails. A significant number of payment rails around the world use the dollar to settle transactions, giving the US the upper hand to control cross-border transactions passively. This could be an unrealised problem for other central banks around the world too.
Digital Yuan Development
- Cross-Border Inter-Bank Payment Service (CIPS)
PBoC created the Cross-Border Inter-Bank Payment service (CIPS) in 2015 to challenge the dollar-dominated global payments system. Accepted by
large banks and financial institutions, including Citibank, HSBC, and JPMorgan Chase, the CIPS facilitates RMB transactions globally. This attempt to internationalise the RMB has limitations, as the CIPS has only
1,300 participants compared to The Society for Worldwide Interbank Financial Telecommunication’s (SWIFT) which has
10,000 participants. However, it must be noted that CIPS and SWIFT have different functions. SWIFT does not move any funds. It is simply a secured messaging system that allows participating banks to communicate with each other. On the other hand, CIPS is an RMB clearing mechanism, which makes it similar to the US’ Clearing House Interbank Payments System (CHIPS), which uses the SWIFT network to settle dollar-denominated transactions.
To achieve the goal envisioned by the latest Financial Standardisation Five Year
Plan (2021-2025) released in early 2022, China must increase CIPS’ network and effectiveness to further improve RMB’s internationalisation. More importantly, China must also make structural economic changes to make the RMB an internationally recognised safe asset and strengthen its share in total global reserves, despite being added to the
Special Drawing Rights basket by the IMF in 2016.
On the other hand, CIPS is an RMB clearing mechanism, which makes it similar to the US’ Clearing House Interbank Payments System (CHIPS), which uses the SWIFT network to settle dollar-denominated transactions.
- The Belt and Road Initiative (BRI)
Greater internationalisation of the RMB is also critical to the success of China’s Belt and Road Initiative (BRI), a strategic plan to connect the main economic corridors in Asia, Europe, and Africa by enabling more extensive trade and investment opportunities between China and almost seventy countries. The BRI aims to develop mutual benefits by investing in infrastructure in the participating economies and creating additional markets for Chinese products and services. A significant portion of all BRI investments is in developing infrastructure projects – highways, railway networks, shipping ports, and industrial parks. Apart from developing soft power in several countries, the BRI allows China to issue RMB-denominated debt and spread the usage of the currency across Asia, Europe, and Africa.
However, since the inception of the BRI, the US dollar has remained the main currency for investment—only
14 percent of all loans being RMB denominated. Such imbalance is in stark contrast with the rise in BRI investments and China’s global economic status, which is similar to the current situation of China’s global trading position and RMB utilisation. According to the Asian Development Bank, Asia requires
US$26 trillion in infrastructure investment over the next decade, and China is uniquely positioned to make these investments. The digital yuan allows China to issue more debt in RMB and strengthen networks and mechanisms for debt repayment. China is already working towards increasing RMB usage for BRI. For instance, China is now the largest
trade partner with 25 BRI-participating countries and has currency-swap agreements with 20 countries. Additionally, the Bank of China and China Construction Bank are issuing offshore RMB-denominated bonds to finance BRI projects.
The BRI aims to develop mutual benefits by investing in infrastructure in the participating economies and creating additional markets for Chinese products and services.
Another avenue for the expansion of the yuan is in the form of debt in Africa. China is the biggest
bilateral creditor of African countries such as Zambia and Djibouti, which allows them to compel such countries to accumulate digital yuan in reserves to pay back the loans. Additionally, CBDCs increase the efficiency of cross-border transactions, making the digital yuan ideal for remittances in Africa.
Nascent Yuan
Despite such advantages, lack of trust in the currency is perhaps the most critical challenge for RMB’s internationalisation. Digital yuan adoption will require guarantees from Chinese institutions. The escalating trade wars between the US and China and the coronavirus pandemic have further polarised the world and created additional barriers for the yuan. Nevertheless, the BRI could still be a catalyst for the digital yuan in several Asian and African countries. The growth of the digital yuan also depends on the global acceptance of CBDCs and how they integrate into and change the conventional financial system.
The RMB and dollar have a fundamental difference that shapes their international usage. The dollar is largely market-driven, whereas the RMB is government or state-driven. The Chinese financial system is restrictive and limiting due to its economic and political system. Its use by liberal economies propelled the growth of the dollar as an international reserve currency. On the other hand, China primarily maintains capital control over most aspects of its economy to manage RMB volatility.
The growth of the digital yuan also depends on the global acceptance of CBDCs and how they integrate into and change the conventional financial system.
Despite low adoption globally, China still leads the CBDC research and execution race. The digital yuan may not be an international currency yet, but it is certainly
gaining momentum in China. Domestic usage of the digital yuan could have a spillover effect on several international currencies as China has the second-largest economy in the world and is also the world’s largest trading partner. This could be perceived as a threat to the dollar hegemony or as an alternative to the dollar-dominated global financial system. It is too early to assess the impact of the digital yuan, but this could be an excellent opportunity for governments around the world that are developing CBDCs to incorporate insights from China’s digital yuan. For instance, digital yuan transactions can be made without an
internet connection, which can be helpful for financial inclusion programmes in areas without internet infrastructure. While evaluating the political impact of the digital yuan is essential, it is equally important to understand the impact of a digital currency on the financial system, be it in China, the US, or India.
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