Did Covid-19 spur digital currency development? (as published in The Edge on May 22, 2020)

Did Covid-19 spur digital currency development?
By Emir Hrnjic

With people observing social distancing measures during the COVID-19 pandemic, a serious concern has emerged. Can the virus spread via physical money? One research seems to suggest so – tests conducted found that some notes and coins may carry as much bacteria as those present on the soles of shoes or even toilet seats. 

In March, the World Health Organization confirmed that banknotes may carry the coronavirus for several days and advised the use of contactless payments instead. Amid the heightened hygiene awareness, digital currencies came to focus Improbably, the Covid-19 crisis might have prompted central banks to expedite this development.

Recently, the head of the Bank of International Settlements (BIS) Innovation Hub Benoît Cœuré said “the [COVID-19] crisis has exposed the value of technologies which enable the economy to operate at arm’s length and partially overcome social distancing… The current discussion on central bank digital currency also comes into sharper focus.”

China leading the way
While the rest of the world has been discussing and analysing the benefits and costs of digital currency, China’s central bank—the People’s Bank of China (PBOC)— had seized the moment and started a pilot test of the digital yuan, the electronic form of the renminbi with value equivalent to the paper notes and coins in circulation. It has since become the first major economy to introduce a central bank digital currency (CBDC), rolling out the pilot test in three cities, including Shenzhen, Suzhou, and Chengdu, as well as in the Xiong’an New Area.

Also known as “DC/EP (Digital Currency/Electronic Payments),” the digital yuan transactions can be made through smartphone–based NFC technology (Near Field Communication). The technology enables the phones to interact with each other when in close proximity and, thus, allows the digital currency to be exchanged without the internet.

Mobile cashless payments – like Alipay or WeChat pay – have become a part of daily life in China. But the launch of digital yuan – coupled with a recent President Xi Jinping’s call for China to focus more on blockchain – exemplifies China’s continuous push to become the world’s leader in digital currency space. Moreover, digital yuan may even pose a threat to the dollar’s supremacy as an international means of payment. Mainland based English newspaper China Daily went as far as to claim that “[China’s] 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… It may also facilitate integration into globally traded currency markets with a reduced risk of politically inspired disruption.”

Pros and cons
While it may be too early to evaluate China’s experiment, central banks around the world are paying great attention to this development while carefully observing pros and cons of digital currency. 

The truth is, central banks have been studying the use of blockchain technologies for years. The Bank for International Settlements (BIS) views potential CBDCs favourably as they would be backed by the government, and the money supply would be controlled by the central bank. Furthermore, the early versions of the US stimulus bill flirted with the development of a digital US dollar to disburse economic stimulus payments, while The European Central Bank recently released a working paper analysing merits of its potential digital currency.

The pros are there. A Bank of England’s study in 2016 on the feasibility of digital currency pointed out that it could increase Growth Domestic Product (GDP) “by as much as three percent.” The usage could also “improve the central bank’s ability to stabilise the business cycle.” 

Following the rise of cryptocurrencies such as bitcoin, the secure digital transfer of money has become paramount. While Bitcoin’s extreme volatility and low transaction processing capacity hinder its ambition to become a global medium of exchange, digital currency issued by a central bank has a far greater potential to become a trusted medium due to inherent low volatility as well as potential for greater efficiency, lower transaction costs, and large scale.

CBDCs would likely help monetary policy targeting money supply and enable access to real-time data regarding money demand. At the same time, blockchain could support faster, auditable, and in general more transparent interbank settlement systems at decreased settlement costs, while avoiding issues like single point of failure.

As societies become immersed in digital payment, central banks which roll out digital currency could gain the first-mover advantage. Any central bank ignoring the role of digital currency could risk losing relevance in the global economy. 

Challenges to overcome
However, the transition to digital currency adoption needs to be carefully managed. One challenge to overcome is the potential shortfall in credit. As the head of Germany’s Bundesbank, Jens Weidmann once argued, in uncertain economic times, people may choose to put their money as digital currency in central banks, instead of deposits in commercial banks as the former is more secure and holds lesser risk. With reduced deposits also comes a severe contraction of consumer credit which would clearly harm the real economy. As central banks’ digital currency looks set to take on a bigger role in future, commercial banks would have to find alternative sources to replace the deposits. 

The PBOC are aware of this shortcoming: They did not want digital yuan to become a threat to the retail banking system. For this reason they did not make it available directly to the public. Instead, the digital yuan will be used by the PBOC and commercial banks for settlement of transactions which may increase transparency of the Chinese banking system and create more stability. 

PBOC’s playbook calls for implementation of a two-tier system – the central bank will create the digital currency and issue it only to large financial institutions and four largest state-owned banks that will further distribute it to China’s 1.4 billion citizens, just like the issuance of cash. 

Another major challenge is privacy. Digital currency enables digital tracing of all digital cash in circulation and, thus, a person’s use of finances. While this considerably helps authorities to fight money laundering, terrorist financing, and even tax evasion, it also facilitates close surveillance and control of individuals’ transactions. In countries where privacy is a great concern, this may lead to serious public opposition. 

Even though PBOC promised to keep the balance between privacy and supressing criminal transactions, it remains unclear how it can achieve balance between these diametrically opposite objectives. Early reports hint at limits in the frequency and amounts involved in anonymous transactions.

As an improbable consequence of COVID-19 crisis, CBDCs were brought in focus and governments might have been prompted to expedite their development. Seizing the moment, China’s central bank made major steps toward becoming the first major economy to issue a CBDC. How other central banks follow suit will be something that markets will play close attention to.