PBOC Keeps Faith in Digital Currency (as published in South China Morning Post on September 21, 2019)

PBOC Keeps Faith in Digital Currency
By Emir Hrnjic and Nikodem Tomczak

Deputy director of the People’s Bank of China’s (PBOC) payments division, Mu Changchun, recently announced that the issuance of China’s central bank digital currency (CBDC) is imminent. China’s CBDC will partially replace cash in circulation which will likely help forecasting targets for money supply and enable access to real-time data regarding money demand. This, in turn, would help PBOC to effectively tighten control over the monetary policy with the objective, according to Mr. Mu, to “protect [China’s] monetary sovereignty and legal currency status.”

China’s CBDC would partially rely on a distributed ledger technology (DLT) and will be primarily designed to handle large transaction volumes expected in a country with the world largest population. In fact, PBOC believes that the DLT would not be able to support a volume of simultaneous transactions such as the volume on Singles’ Day – the largest online shopping day in the world. 

In a proposed two-tier system, the central bank will create the digital currency and financial institutions such as Alibaba, Tencent, UnionPay and four largest state-owned banks will be involved in its distribution to country's 1.4 billion citizens. Eventually, the new digital yuan will be made available to customers outside China. Alibaba owns the Post.

The distributed ledger technology is heavily researched by most of the world’s central banks. A study by the Cambridge Centre for Alternative Finance predicts that more than a third of these organisations would have active DLT applications within 10 years.

The emergence of cryptocurrencies and the underlying DLT have opened up new possibilities for the secure digital transfer of money. The typical features of cryptocurrencies – the public ledger, immutability, and its decentralised nature – are hard to be incorporated into centralised banking.

A central bank digital currency powered by DLT would nonetheless support faster, auditable, and more transparent interbank settlement systems. 

However, not all countries support the introduction of a CBDC. Australia, New Zealand and South Korea have raised concerns about its effect on the stability of the financial system. In their argument against CBDC, they cited risks associated with “credit, liquidity and legal management” and “significant implications for the [central] bank's financial stability mandate.”

Indeed, introduction of CBDCs available directly to the public could lead to unintended consequences during economically uncertain times. For instance, credit contraction could be exacerbated by commercial bank customers transferring their funds to a more secure and risk-free CBDC, starving the commercial banks of access to deposits. This, in turn, would lead to a large contraction of consumer credit, harming the real economy.

The mainland's digital currency, however, will not be available directly to the public and will not compete with commercial bank deposits. It will be used by the PBOC and commercial banks for settlement of transactions. This may increase transparency of the Chinese banking system and create more stability.

Reuters reported that the mainland's digital currency would “strike a balance between allowing anonymous payments and preventing money-laundering.” In fact, tracing digital currency transactions on an effectively centralised ledger should be simple and effortless. Hence, a China’s digital currency will enable the central bank to track money laundering, terrorism financing, and other illegal activities.

On the other hand, this represents another potential drawback of a China’s digital currency as it will give a central bank the power to observe and control individuals’ finances and transactions, including those happening on China’s successful mobile payments applications.

Nonetheless, the Bank of England’s study concluded that CBDC issuance “could permanently raise GDP by as much as three percent… [and] could substantially improve the central bank’s ability to stabilise the business cycle.”

As DLT and regulations mature, central banks may need to implement digital currencies or risk losing relevance in the global economy. Commercial banks have to react to successful CBDCs too, and plan to replace deposits with other sources of funds. 

Central banks need to bear in mind that, in the transition to the central bank issued digital currencies, they must not lose sight of their primary role – maintaining trust in money.