While the rest of the world is focused on recovering from the coronavirus pandemic, China has made another powerful move in the realm of global finance that could have major long-term geopolitical implications. The country is preparing to launch a pilot run of a central bank digital currency (CBDC), making the People’s Bank of China the first major central bank to translate its extensive digital currency efforts into a ready-to-use product. China began internal tests of its CBDC in early May, though the official launch is not expected until later this year.
As the first entrant in the CBDC market, China has a head start in a race that could change the future of money. Perhaps most noteworthy, a digital currency backed by the People’s Bank of China could play a key role in the country’s efforts to dethrone the U.S. dollar as the world’s primary reserve currency.
Streamlining Global Payments
Early adoption of such a digital currency gives China an advantage in terms of setting both standards and a working model for others to follow. China also has the opportunity to create a new payments architecture in which the so-called digital yuan becomes a widely accepted currency.
China has been steadily internationalizing its currency to challenge the dollar’s dominant position as a global reserve currency. Because the dollar is so ingrained in the existing financial system, China has yet to make much headway. But that could change if it manages to create a more efficient and secure alternative payment infrastructure with its CBDC.
In the short term, China’s new digital currency could potentially address several gaps in the payment industry. Cross-border payments currently require multiple hops of communication, transfers via correspondent banks, and effective liquidity management. This makes the payment transfer process slow and costly: according to the World Bank, cross-border transfers of funds cost on average 7 percent of the transaction amount. Furthermore, most dominant cross-border payment networks operate as closed user groups that do not easily integrate with other systems. As consumers and businesses grow accustomed to instant domestic payments, demand for similar cross-border capabilities is rising.
China’s digital yuan could help meet this demand by establishing a peer-to-peer network between central banks that would cut out financial intermediaries between payers and payees. Establishing such a system of infrastructure could allow actors to clear payments in real time with reduced costs and frictions. If China, the world’s second-largest market, manages to successfully create an interoperable system to initiate and process CBDC payments, it is likely to be widely adopted for cross-border transfers elsewhere.
Sharpening China’s Financial Edge
China has many avenues to expand its influence over global financial markets through its CBDC. First among them is the Belt and Road Initiative, a China-led economic development initiative focused on infrastructure investment that spans Asia, Europe, and Africa. Using its digital currency to settle cross-border transactions would enable China to almost completely bypass the existing U.S.-centric financial system while conducting business—a change that could significantly increase the share of renminbi (RMB), the official Chinese currency denoted in yuan, in international transactions.
China is also likely to use the digital yuan for bilateral trade. Its most recent trade agreement with Pakistan advances these plans by transitioning payments from U.S. dollars to the two countries’ own currencies. Moreover, Pakistan’s central bank has allowed other commercial banks to receive deposits and provide trade loans in hard-currency yuan.
The RMB presents the greatest threat to the dollar in South and Southeast Asia, where China is a major, influential investor. China has set the stage for an expansion of its CBDC by increasing the magnitude of RMB circulation in its territories and neighboring countries. In Hong Kong, for example, the RMB is the second-largest exchange currency after the Hong Kong dollar. Nepal and Cambodia have allowed the official circulation of RMB. As for Mongolia, RMB notes account for three-fifths of the cash that is circulating countrywide. In South Korea, the RMB is accepted in shops and restaurants. In Taiwan and Vietnam, it can be exchanged through unofficial and official banking channels. Only a few currencies—chiefly the dollar, the euro, and the yen—enjoy easy convertibility, making it notable that the RMB’s convertibility is expanding, at least among China’s neighbors. Other countries in the region like Sri Lanka and Bangladesh are also becoming increasingly economically dependent on China.
An increase in the circulation of RMB translates to increases in foreign trade and financial transactions settled in RMB. Those gains create more opportunities to use China’s CBDC in cross-border settlements. Given the hoped-for benefits of digital currencies, and with a little persuasion in the form of aid or other incentives, countries are likely to accept China’s CBDC over the dollar for bilateral trade settlements with Beijing.
Furthermore, China has been steadily building up its economic and diplomatic relationships in Africa, where it pledged $60 billion in unconditional aid in 2018. It could leverage that influence to convince countries across the continent to move away from the dollar. As the coronavirus pandemic leaves the International Monetary Fund and the World Bank overburdened with aid requests, China has further opportunities to strengthen its position as a donor and nudge countries to accumulate yuan reserves.
The People’s Bank of China has already set up yuan clearing banks in several major countries—including France, Germany, Japan, Russia, Singapore, South Korea, the United Kingdom, and the United States—to encourage economic partners to use the RMB as a hard currency. In addition, it has roped in several institutions around the world to participate in the Yuan Cross-Border Interbank Payment System, whose offshore centers offer easy RMB conversion.
Finally, one of China’s most important achievements was the inclusion of the RMB in the International Monetary Fund’s Special Drawing Rights (SDR) valuation basket starting in 2016—a status that lends the RMB legitimacy and makes it easier to exchange.
A Long Way to Go
The renminbi may be garnering acceptance as a hard currency in parts of Asia and Africa, but it’s nowhere near replacing the dollar as the world’s default reserve currency. While China increases its share of global trade and builds trust in the RMB, several challenges to greater dominance remain. The country’s protectionist policies, tight control on capital flows, and lack of transparency around monetary policy hamper the RMB’s potential as a reserve currency.
Going forward, trust in the information flowing out of China will be key. A shift in the world’s default reserve currency will require enormous change. While global willingness to adopt such a change depends on many factors, it remains highly unlikely in the short term, given the massive financial disruptions caused by the coronavirus pandemic and suspicions around China’s initial response to the outbreak.