The era of precision economic statecraft. Notes on China’s central bank digital currency

"China has many advantages and opportunities in issuing fiat digital currencies, so it should accelerate the pace to seize the first track," an article published in the magazine run by the 中国人民银行 openly commanded. There are numerous reports that the Biden administration is worried. At present, anything coming from China is a source of worry, of course. I suspect that if China announced it had a new plan to develop the practice of cricket in the country, think tanks in Washington would call it a bold move and demand billions in extra investment. Still, the global monetary system is special.

I have also been amused — greatly amused — by the comparisons to crypto. Caveat emptor: a fiat digital currency is not crypto because crypto is not defined by running on software and dispensing with physical tokens. The digital yuan is not decentralized, not permissionless, not trustless, not scarce, not distributed… Obviously, a central bank digital currency does not have a lot in common with crypto currencies. With one exception: they both serve to disintermediate the traditional banking system. I suspect China will find it much easier to create a fiat digital currency because banks are subject to political control. If the Party wants them to take a back seat, that is exactly what will happen. It is somewhat different in the United States. Or Russia. In Sweden commercial banks have been pushing back hard against the Riksbank’s proposal for a digital currency.

Official statements and documents give no clear answer to the basic question of what the new digital currency project is for. Here are some ideas:

• A central bank digital currency creates powerful new tools for monetary policy. Call it precision monetary policy. Interest rates and quantitative easing are blunt instruments. Untailored stimulus floods into asset prices, doing little for the real economy and adding to financial instability. Even before it started looking into central bank currencies, China had pioneered something of a more tailored approach to monetary policy: the policy of separately targeting the interest rate on loans and the interest rate on deposits was invented in China before being embraced by the European Central Bank. A digital currency opens up a whole new world of possibilities. First, interest rate changes by the central bank would be more direct relative to bank deposits. Second, the money supply is programmable. A stimulus package of transfers could be programmed to lose a percentage of value if it is not spent, encouraging consumption — or even include an expiry date. It could be programmed in such a way that it has to be spent locally or on certain goods. Central banks around the world pay interest on the reserves of commercial banks held electronically at the central bank, but strangely households and individuals receive no interest on their cash holdings. Theoretically, a remunerated central bank digital currency (CBDC) could immediately pass on interest rate changes to holders and users of the currency, eliminating a persistent chokepoint in the transmission of monetary policy decisions. If the economy encountered a severe adverse disturbance that exerted downward pressure on the general price level, it should be feasible for the central bank to reduce interest rates as needed to foster economic recovery and price stability. Interest rate adjustments would no longer be constrained by any effective lower bound in response to severe adverse shocks. That lower bound has been a key reason why many central banks currently aim at positive inflation rates of 2 percent or more, whereas a CBDC will essentially eliminate the need to maintain such an “inflation buffer” or to deploy alternative monetary policy tools such as quantitative easing or credit subsidies. Endless possibilities.

• Better monetary policy can become a critical tool in the ongoing global competition between China and America. It can help the former tread a path of solid money. The contestant with extra sound money usually wins. And think of the political damage of quantitative easing: wealth effects emerge only incidentally and are concentrated in the hands of those abundant in risk assets but short on opportunities for the middle class.

• Zhou Xiaochuan, the previous governor of the PBOC, commented in 2019 that the financial industry is mostly an “information industry.”

• In the United States, interest rates are at his­toric lows, but the political will for an interest rate rise is no longer present because it would have such a devastating impact on bond markets and the real economy. The question is whether investors will continue to flow to the dollar if the currency can no longer generate yield. Should we be surprised that in places such as Myanmar people now seem to prefer the local currency? “I feel safer now when I have kyat rather than U.S. dollars,” said Zaw Moe Ko, a business professional in Yangon. The kyat has gained as much as 11% versus the dollar this year. A fiat digital currency “can facilitate interest rate arbitrage, and in so doing suck dollar funding away from the Western financial system.”

• Zhou Xiaochuan notes that China and other East Asian countries can try to develop cross-border transactions using new digital currencies. That could come with the internationalization of the yuan, but he also adds that the process “should not be overly promoted.” The dollar is the global reserve currency because the American consumer is the consumer of last resort. Reserve currency status has nothing to do with transaction costs and the world will certainly not switch to the renminbi because it likes the functionality of the digital yuan. It is very difficult for me to see how the digital yuan could become a global standard. China could let foreigners visiting the country open up digital wallets, but it is an open question whether those visitors will be able to keep their digital funds on their phones when they leave the country or use them anywhere outside of China. If it chooses to allow foreigners to use the wallets abroad or even go further and promote wallet use among foreigners, that would mean operating as a payment provider in foreign jurisdictions, requiring licenses and compliance with a host of local rules in a highly regulated space. A cunning plan? Not really.

• The digital yuan could potentially create new capacities for bypassing sanctions by evading the global mechanism by which financial institutions are able to communicate with each other, sending and receiving information about transactions in order to complete transfers and settlements. Chinese banks are vulnerable. By removing the banks from the payments system, a sovereign digital currency provides a functional alternative to the dollar settlement system and blunts the impact of any sanctions or threats of exclusion both at a country and company level.

• As Yaya Fanusie recently argued, the digital yuan would allow China to deploy economic sanctions of their own. With the flip of a switch, certain companies could be removed from the national payments infrastructure. Perhaps more interestingly, “it might also be possible to place volume limits on DCEP transactions to firms as a way to throttle sanctions against them.”  Such granular economic statecraft is not possible under a conventional banking infrastructure.