In recent military exercises around Taiwan, China has simulated an invasion of the island, which it considers a "rogue province". Talk of the war has kept Chinese bloggers, pundits and politicians busy since US House Speaker Nancy Pelosi visited Taipei in August.
There is no doubt that Beijing's finance officials have also been preparing for a conflict. They have watched in amazement as the United States and its allies imposed crippling sanctions on Russian banks and banned seven of them from the SWIFT system, a messaging network used to send payment instructions. A Chinese invasion of Taiwan would lead to similar measures, with a consequent freeze on Chinese banking activity abroad. In a military war for control of Taiwan, no one knows who would win. In a financial war, American victory seems assured.
China's reliance on the dollar has long been a source of frustration in Beijing. It not only cements the country's vulnerability to sanctions, but also exposes it to the macroeconomic whims of the United States. For many officials, it is perverse that their country, the world's largest exporter and official creditor, is so dependent on the currency of the largest importer and borrower. China has been trying to promote its own currency, the yuan, as an alternative for more than a decade. However, progress has been hampered by another source of Chinese discomfort: uncontrolled capital flows. The limits that China imposes (to avoid speculation) on the circulation of its money make it difficult for the world to adopt the yuan.
As a result, few bankers believe that the yuan will soon replace the dollar as the preferred world currency. However, that is not the only prize worth getting. There are other more feasible and more pressing goals. In particular, Chinese technocrats aspire to create a payments system that is easier for their trading partners to use and harder for the United States to block. They also hope that such a system will make the yuan more influential abroad, without compromising capital controls within China's borders.
New technologies will be of great help. China has been testing a digital version of the yuan, now known as e-CNY, since May 2020. Residents of 23 pilot areas in 15 provinces have downloaded “electronic wallets” onto their phones. These are wallets provided by banks or popular payment platforms, such as Alipay. However, the electronic money they contain represents a liability of the central bank. More than 260 million individuals and 4.5 million businesses already handle the digital yuan, according to the People's Bank of China (PCB), the central bank. Thanks to promotions and subsidies, the digital currency has been used in more than 260 million transactions amounting to about 83 billion yuan ($12 billion) from its inception to the end of May, with an average transaction value of about 300 yuan.
China insists that e-CNY is first and foremost for domestic use. Officials fear innovations like Libra and Diem, the digital currencies proposed by Facebook. They also want to have a secure backing, and perhaps a rival, against Alipay and WeChat Pay, the hegemonic private payment platforms. For that reason, e-CNY has been designed for use in retail. It can be in the hands of individuals and non-financial companies, rather than just in the hands of banks.
However, a few Chinese academics are in favor of expressing higher ambitions. According to Sun Lijian of Fudan University, a digital yuan will help break the monopoly position of the dollar and could be used to finance projects related to the new silk routes (Belt
The e-CNY has the potential to contribute in various ways to the internationalization of the yuan. It can make it easier and cheaper for foreigners to make cross-border payments and make it more difficult for the United States to block those transactions for geopolitical purposes. With which the yuan would see its attractiveness increase, even in the event that China maintains capital controls. The digital yuan can also change how those controls work, by programming them into the currency itself.
Within China, e-CNY payments are currently fast and free. (The central bank may, according to China's Caixin magazine, in future charge a fee to wallet operators and related services, if not to end users.) The PBOC has made no announcement about how it might receive a wallet a foreign user. The Chinese banking community is a hotbed of speculation. Some believe that Chinese regulators will create a special financial zone where users from abroad will be able to apply for wallets. There, banks and other financial services companies would be invited to create "know your customer" businesses in the selection of applicants. Approved foreign users would operate remotely through Chinese banks in their home countries.
Once a foreigner is entitled to a wallet, e-CNY transactions with other wallet holders would be quick and cheap, even if they are separated by a geographical border. In the early stages, most transactions would be with Chinese companies or customers. Now, once the number of foreign wallet holders has reached a certain critical mass, some payments will not need to have a Chinese user on the other end of the transaction.
Forex trading seems like a more distant prospect. However, China's experiment with e-CNY has prompted many other governments to look into their own digital currencies and how they might be exchanged. We have, for example, mBridge, a program created by the Hong Kong Monetary Authority that has been joined by the PBC, the central banks of Thailand and the United Arab Emirates, as well as the Bank for International Settlements, a club of central banks based in Switzerland. One of the initial goals is to allow digital currency transactions within the Greater Bay region, a large region in southern China where three currencies (the yuan, the Hong Kong dollar and the Macanese pataca) currently operate. The involvement of other central banks indicates that mBridge's long-term ambitions are much higher.
These types of platforms have the potential to help settle international payments at a fraction of the cost of the current model of correspondent banking. The technologies underlying digital currencies have been proven to reduce the transaction, energy and storage costs associated with traditional systems. The abandonment of centralized clearing and the creation of competition between various platforms could also contribute to the reduction of costs. For China, the project is strategic, not commercial, so it will almost certainly try to undercut the price of other systems, according to a recent article by Ross Buckley of the University of South Wales, Douglas Arner of the University of Hong Kong and other coauthors.
Such systems will also be less vulnerable to sanctions. The US response to Russia's war in Ukraine has shown that Western powers have a great facility for weakening foreign banks by kicking them out of the SWIFT system. In addition, the United States can prohibit its financial institutions from dealing with a sanctioned country, thereby making it impossible for banks in that country to settle dollar payments with the rest of the world. Payments in e-CNY will use neither USD nor SWIFT, thereby bypassing commercial banking institutions entirely.
e-CNY may make America's financial weapons less adept and less accurate, and will limit its use. Now, it won't render them completely useless. Even if the United States is unable to directly prevent an e-CNY transaction from taking place, it may deny access to its clearing system to any institution that uses the digital yuan in a way that it does not consider to its liking (i.e., to serve a country subject to sanctions), which will be a powerful tool of deterrence and punishment. Since the United States will not be able to monitor e-CNY activity as closely as it does oversight of dollar payments, some transactions will escape its notice. In the event that an inaccessible e-CNY becomes too great a threat to its sanctions regime, the United States will be able, in theory, to ban its use by any institution that wishes to continue to access the US clearing system. That would force the world to choose between the dollar and the digital yuan.
Lower transaction costs and less vulnerability to sanctions will make the digital yuan more attractive to foreigners. Other features may make its use abroad less stressful for Chinese authorities. Chinese rulers are less concerned about capital leaving the country than about currency leaving. They are very cool about Chinese companies and residents accumulating yuan-denominated credits in the rest of the world. However, they are concerned about speculative moves against the currency, especially if those moves develop their own speculative momentum. Within China, regulators can limit the amount of yuan that residents can sell for currency. They can also question residents about why they want to buy dollars. Instead, they do not have the same control over non-residents; especially if they hold yuan in foreign banks.
Various aspects of China's current financial framework betray this nervousness. Its Cross-Border and Interbank Payment System (CIPS) has been slow to admit foreign banks, for example. Within that system, yuan payments can leave China, but remain within a circle of trust of mostly Chinese intermediaries. Its Wealth Connect wealth management program, introduced last year, creates another kind of closed loop. It allows wealthy people from China to buy investment products in Hong Kong, thereby gaining exposure to assets denominated in foreign currencies. However, when they withdraw those investments, they can only do so in yuan. This prevents large amounts of yuan from leaving China.
The e-CNY will allow another closed circuit. Transactions in digital yuan are made through the balance of the Chinese central bank. That makes it easier for authorities to control the use of Chinese currency even among non-residents. Since e-CNY can only circulate between approved e-wallets, Chinese authorities also have the means to weed out potential speculators during the approval process. Digital wallets are likely to encode a number of user characteristics, such as the country of residence and the industry in which they work. Such data will be used to grant or deny people and businesses access to yuan payments, or limit their payments to certain amounts. Thus, China will be sure that any digital yuan circulating outside its borders will not fall into the wrong hands for the wrong reasons.
The Chinese digital currency is also "programmable". The e-CNY can be distributed with conditions, such as a deadline to spend it. In theory, it is possible to program any condition into digital currencies, explains Michael Sung of FreeFlow Finance, a cross-border payments company. Regulators have the ability, for example, to codify currency selling limits. That will help them limit any speculative moves against the currency, even if the yuan is held by foreigners outside its conventional regulatory reach.
Imagine, for example, that e-CNY e-wallets are issued to a number of grain traders in Africa and also to related businesses such as farmers, pesticide sellers and logistics companies. The money loaned to those companies could be programmed so that it could only be exchanged between approved companies within the supply chain. The BPC could also closely monitor payment flows. It would be easy to stop exchanging e-CNY to other currencies with unapproved banks.
Such control and the global view of the currency will make the PBC much more comfortable in allowing greater flows of its currency into trade finance and supply chains. According to Charles Chang of Fudan University, authorities have already tested changes to the yuan's convertibility rules in Hainan. Officials have declared that Hainan will become a free-trade port in 2035. They plan to turn the island province into an offshore trade and finance hub, with a role similar to that of Hong Kong. It is not hard to imagine that such a financial zone will be used as a base for conducting trade finance with digital yuan, Chang adds.
But will users outside of China want that? In poorer countries, it probably is. Securing dollar financing in poor parts of Africa is sometimes extremely difficult. The offer is limited. Entrepreneurs often wait weeks and pay huge sums and bribes to access it. Many companies in poorer countries already opt for trade financing in yuan when it is available. The move to e-CNY will be a great help, as long as there is a wide offer and users from abroad can get digital wallets.
A restricted currency is naturally less attractive than an unrestricted one, just as food stamps are worth less than their cash equivalent. Therefore, a programmed digital yuan will be less attractive than a currency without such limitations. However, if China's conventional currency remains hard to come by due to government jitters over speculation and misuse, then the digital yuan will become a viable alternative. It will be used less freely, but with more availability. Also, most users of a coin have no intention of selling it in a panic unless everyone else is. Therefore, technological caps designed to prevent speculative moves need not prove fatal to the digital yuan's international appeal.
Much of what has been said still belongs to the realm of speculation. Given the heightened tensions with the US, the internal deployment of e-CNY will not bring much comfort to Chinese technocrats worried about a possible conflict. However, in the long term, the digital currency will acquire importance. Perhaps it will end up helping the yuan to spread around the world without getting out of its lane.
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Translation: Juan Gabriel López Guix