The People’s Bank of China (PBOC), China’s central bank, is expected to publicly launch a digital version of the yuan as soon as late 2020. The project is being fast-tracked, partly in response to Facebook’s Libra and the COVID-19 pandemic. The PBOC has rolled out pilot tests in at least four cities, reportedly with the participation of U.S. businesses. While various countries are conducting research and development on central bank digital currencies, China is significantly ahead and appears poised to be the first large economy to issue such a currency.
The digital yuan is 100% programmable and trackable, meaning the Chinese government can monitor capital flows in great detail and impose limitations or preconditions on the currency’s use.
The digital yuan poses meaningful threats to the diplomatic, informational, and economic interests of the United States and its allies. Among them, the digital yuan will help China internationalize its currency, promoting the yuan as a rival or alternative to the U.S. dollar; enable China to expand and export its surveillance capabilities by providing a window into and control over the economic activity of users within its borders or abroad; and allow China to circumvent sanctions, arms embargos, and money laundering regulations by providing an alternative to the existing dollar-based system of international payments, which is policed by Western financial institutions.
Facebook, COVID-19, and the Digital Yuan
The PBOC has been researching its digital currency since 2014. The currency has yet to be officially named, but China refers to the initiative as “digital currency/electronic payments.” The publicly stated reasons for pursuing it include reducing costs associated with managing paper-based cash; improving the effectiveness of monetary policy via real-time data and controls; speeding up and reducing the cost of international payments; and fighting money laundering, terrorist financing, and other criminal activities.
The PBOC is also concerned about China’s overwhelming dependence on electronic payments; 93% of mobile payments are handled by TenPay (WeChat) and AliPay (Ant Financial), so if their networks were to fail or be compromised, then there wouldn’t be enough paper currency in circulation to support commerce, potentially causing collapse or panic in the financial system. Beijing is also keen on keeping control of and monitoring capital flows, and while TenPay and AliPay permit government monitoring, they don’t provide Beijing with the degree of direct control and monitoring that the digital yuan will.
Officials accelerated the digital yuan project when Facebook announced in June 2019 its intention to launch its Libra digital currency. The PBOC views the Libra as a threat to the yuan and to China’s domestic payments systems. Because Facebook wouldn’t include the yuan among its reserve currencies, widespread Libra use could result in capital outflows, weakening the yuan.
Facebook has run into strong regulatory headwinds due to the Libra’s far-reaching potential impact on the Western-dominated global financial system and the ability of central banks to control monetary policy. Unlike Facebook, of course, China does not answer to foreign regulators, regardless of concerns about the digital yuan.
In addition to Libra, the COVID-19 pandemic has intensified the initiative’s urgency. There are fears that the paper-based cash supply could be contaminated: the PBOC has been disinfecting cash and storing it for up to 14 days. Second, the digital yuan would enable China to monitor and control spending under its $3.6 trillion stimulus package. A large percentage of China’s consumer and business transactions are already handled digitally, and China, like other governments, is almost certain to conduct surveillance on them. The centrally controlled digital yuan, however, takes this to another level. If the central government distributes multi-billion yuan stimulus payments using the digital yuan, it could essentially tag the funds and dynamically filter or restrict how ministries, cities, and other recipients spend it. Every expenditure of the stimulus package would be tracked and recorded. Large conversions to cash or transfers to personal accounts—telltale signs of corruption—could be detected far more easily than in the past, when funds were transferred to recipients’ bank accounts and distributed locally. Such transactions could even be automatically flagged using machine-learning techniques. This could reduce the type of widespread corruption that took place under China’s financial crisis stimulus in 2008.
Although no official launch date has been set, Citic Securities, a major Chinese investment bank, has forecast that the digital yuan would be formally rolled out by the end of 2020. Already, China has completed the top-level design of the digital yuan, and began pilot testing in 2019 to ensure its stability, security, and control. Testing began in four regions (Chengdu, Shenzhen, Xiongan, and Suzhou) and is now expanding broadly to Beijing and to the south of the country. Its initial use is across transportation, education, and health care in partnership with seven state-owned banks and telecom firms. A state-backed Chinese publication reported that Starbucks, McDonalds, and Subway are among 19 businesses participating in one test; Starbucks has denied the report.
Characteristics of the Digital Yuan
As a token-based currency that may eventually include blockchain technology, the digital yuan will offer modernization and benefits that businesses and individuals worldwide are seeking. Transactions occur instantaneously without the need for a bank or other intermediary. They are secured by robust encryption and tracked on an indelible digital ledger. This approach is faster, cheaper, and theoretically more secure than the current SWIFT system, under which transactions can take days to complete and which has recently been the target of multi-million dollar thefts.
The digital yuan will be distributed in a way that largely preserves institutional channels of cash distribution. However, in addition to a select group of commercial banks, the PBOC will issue and redeem the currency via the Chinese banking association Union Pay and payment service providers Ant Financial (AliPay) and Tencent (TenPay/WeChat). These banks and financial institutions will then distribute it to businesses and individuals through PBOC-authorized digital wallets. Users will be able to make payments or transfer money online or offline via near field communication, and no bank account will be necessary to use a digital wallet or move money.
The digital yuan stands in stark contrast to the more than 1,600 cryptocurrencies currently in existence. It is a fiat currency, designed for widespread use as a replacement for cash. Initially at least, it will be backed yuan-for-yuan with hard assets, and financial institutions will be required to maintain a 100% reserve ratio on the currency. This reserve requirement eliminates the valuation risk versus the paper-based yuan and prevents the digital currency from being traded as a security, vulnerable to speculation. Consistent with its initial role as cash in circulation, the digital yuan will not yield (or require) interest payments, and it will not replace other parts of the money supply, such as bank deposits.
The government is also expected to incorporate layers of automation to control usage of the currency for specific activities at specific times. For example, during market shortages, users of the currency may only be able to buy certain quantities of scarce materials. More socially invasive examples of such automated control mechanisms would be to combine China’s surveillance programs like the Social Credit System and Skynet to prevent socially untrustworthy individuals from travel, deny them licenses, or mandate enrollment in social education programs.
Internationalization and U.S. Dollar Reserve Currency Status
China’s effort to establish the yuan as a reserve currency has achieved steady, but limited, progress. In 2016, it became an official reserve currency held by the International Monetary Fund (IMF), and it is now the world’s fifth largest reserve currency. Still, at the end of 2019, only $221.5 billion yuan was held in official exchange reserves (2%), compared to $6.8 trillion (62%) in U.S. dollars.
Observers believe that the digital yuan is an effort to substantially boost the yuan’s international status, establishing it as a currency for everyday transactions around the world. China has numerous levers that it could use to proliferate use of its currency. Domestically, its use could be mandatory for accessing public services, such as healthcare, public transportation, and utility services. China has also signaled that it wants the digital currency to be in use during the 2022 Beijing Olympics; the numerous foreign visitors present an opportunity to proliferate use of its digital wallets.
Abroad, because no bank account is necessary, the digital yuan could appeal to the world’s approximately two billion unbanked individuals (a key target of Facebook’s Libra). China could use the digital yuan to fund transactions under its Belt and Road Initiative, which invests in some 65 countries. The superior speed, convenience, and safety offered by the digital yuan could make it appealing to the many international businesses involved in trade with China, with close trading partners in Asia and beyond. The portion of China’s foreign trade settled in yuan has risen to 15%. More than half of payments between France and China are handled in the redback. A digital yuan that moves at the speed of modern commerce may accelerate this.
To date, efforts to internationalize the yuan have been hampered in part by China’s foreign exchange controls and a dearth of trust in the Chinese government as a steward of wealth. Establishing the digital yuan as an international currency would alleviate much of the need for China to impose foreign exchange controls by reducing the risk to the yuan’s exchange rate and enabling China to expand its surveillance capabilities abroad.
Regarding trust, Beijing is betting digital yuan users will agree that having big brother watching is a small price to pay for utility, convenience, and collective security. Undoubtedly, this position will decrease the digital yuan’s appeal to the privacy-minded citizenry of developed nations. But as we’ve seen in the international diplomatic campaign led by the United States against Huawei, less developed nations may be less concerned, resigned to the reality that clandestine surveillance by all the great powers is simply an existential condition.
Surveillance and Control
Recognizing that anonymity is part of the appeal of existing paper- and crypto-currencies, the PBOC has promised that the digital yuan will feature “controllable anonymity.” The idea is that transactions would be anonymous from the users’ perspective—users on the network will provide identifying information on a voluntary basis to other users—however, the PBOC will maintain the ability to monitor and track the entire user network.
The reality is that a mature digital yuan system, potentially implemented through blockchain and other technologies, will create a permanent, government-owned ledger in which every transaction is recorded and traceable via users’ digital wallets. Nothing would stop China, as the blockchain’s centralized owner, from freely conducting surveillance of any data collected through the system. Indeed, a patent application shows that the PBOC has researched ways to track digital cash.
The digital yuan essentially enables China to export its state surveillance system, following its own citizens abroad and gathering data on any other person or business that uses the currency. Users will be trusting their personal information not only with current authorities, but also with future ones in perpetuity. Meanwhile, the digital yuan’s strong encryption may make it practically impossible for others (such as foreign intelligence organizations) to trace transactions or otherwise conduct surveillance. This contrasts with the SWIFT network, a messaging service that practices transparency in its transactions and that plays an important role for many institutional and official crime fighting initiatives.
Surveillance, however, is only part of the threat posed by the digital yuan. The currency will also give China a powerful new lever to control users. The PBOC has publicly stated that it and the financial institutions that distribute the currency will have the ability to immediately freeze any digital yuan or accounts involved in suspicious transactions. It could also exercise its ability, as the central authority and exclusive owner of the system, to code how money is spent. There are benign uses of this capability. For instance, if China allocates money to be lent to small businesses, it could code the digital yuan to activate upon deposit in the wallet of such an enterprise. But it’s not hard to imagine the new currency being used as an instrument of state power, especially when combined with powerful surveillance programs already in place and with facial recognition technologies, big data analytics technologies, and artificial intelligence.
Sanctions
A mature digital yuan would allow China to bypass Western sanctions, enabling users to trade a major currency internationally without using the SWIFT system. SWIFT’s member banks serve as a critical chokepoint for law enforcement and international policy. They are required to police all transactions on their networks for money laundering, sanctions violations, and other criminal activities. Because of the dollar’s dominant status in international trade, the U.S. government wields a powerful enforcement lever over institutions that fail to comply. This is an essential mechanism that, for instance, enables the United States to monitor transactions related to Iran’s nuclear program. It is also used to enforce sanctions against Chinese interests accused of violating intellectual property laws and human rights violations in Hong Kong, Xinjiang, and beyond.
Conclusion
A central question concerning the eventual success of the digital yuan is whether people and businesses will trust the Chinese government as a steward of their wealth and privacy. Trust is one of the assets that has established the U.S. dollar as the predominant international currency. Still, the Chinese government has many effective means for distributing its currency both domestically and abroad to ensure its widespread use. Moreover, the digital yuan offers features—such as speed, immediacy, low cost, and potentially international ubiquity—that could make it appealing to users across the globe. As we’ve learned during the digital era, users are frequently more than willing to trade privacy for convenience.
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