What is China’s sovereign digital currency?

China’s version of a sovereign digital currency, the so-called Digital Currency Electronic Payment (DCEP), will be used to simulate everyday banking activities including payments, deposits and withdrawals from a digital wallet.

Once launched, consumers would download an electronic wallet application authorized by the People’s Bank of China (PBOC), which they would then link to a bank card to start to pay with or receive digital yuan using a mobile phone with merchants or make transfers with an ATM machine and other users.

The money from the linked bank account would be converted into digital cash on a one-to-one basis. There is also an option that does not require a bank account to hold and conduct transactions in the digital yuan.

Unlike other online payment platforms that are already commonly used in China, including Alibaba’s Alipay and Tencent’s WeChat Pay, the DCEP system supports payment transactions even without an internet connection. The function called “touch and touch” allows two users to simply touch their mobile devices together to make a transfer, leaving no payment record with a third party or the banking system.

Alibaba’s Alipay and Tencent’s WeChat Pay are already popular payment methods in China. (Picture: EPA)

The digital yuan is part of the most liquid form of money supply that includes notes and coins in circulation in the society, known as M0, but in a digital form. It is issued and backed by the country’s central bank.

Why does China want to have its own digital currency?

China's version of a sovereign digital currency is set to revolutionise the ability of regulatory authorities to scrutinize the nation’s payment and financial system as officials will acquire more power to track how money is used by its citizens.

“Looking back years later, the two defining historic events of 2020 would be the coronavirus pandemic, and the other would be [China’s] digital currency,” said Xu Yuan, a senior researcher with Peking University's Digital Finance Research Cen­tre.

From a regulatory perspective, the emergence of a digital currency would enable payment transactions to be made online, making all cash flow in society traceable, according to Xu.

When more business activities and financial transactions are moved online so that cash flow information and credit data is stored on a database, the credit structure of the overall society becomes easier to be determined. The new credit picture could influence the supervisory structure, leading to changes in its methods, means and effects, Xu said.

The database can be checked in real time and play a role in keeping digital records and checks against citizens who have committed money laundering, tax evasions or other related offences.

“In theory, following the launch of the digital yuan, there will be no transaction that regulatory authorities will not be able to see – cash flows will be completely traceable,” Xu said.

The coronavirus pandemic may also be a catalyst for accelerating contactless payments because of concerns that banknotes can transmit Covid-19. The perceptions of hygiene standards and the cost related to the issuance of paper cash could also be improved with the adoption of digital currencies.

China’s potential launch of a digital currency is also in line with its top policy initiative to internationalize the yuan and improve reserve currency status if the DCEP payment system involves cross-border payments for the use within e-commerce by other countries. Compared to paper cash, the digital yuan would reduce transaction costs for enterprises and residents in other countries.

Many economists, however, are skeptical whether the impact of the digital yuan would significantly spread beyond its borders without official reforms to relax the yuan’s exchange rate convertibility.

When did China start planning for its sovereign digital currency?

In recent years, numerous countries have been evaluating the case for issuing central bank digital currencies, but only China and Sweden have gone as far as conducting tests. Both countries have seen the use of physical cash rapidly disappearing due to the high penetration rate of smartphones and therefore electronic payments.

The PBOC began exploring the concept of a national virtual currency in 2014 with the success of ecommerce platforms Alibaba, Tencent and Baidu. Mobile transactions reached 347 trillion yuan (US$49 trillion) in 2019, accounting for four of every five payments.

The central bank’s Digital Currency Research Institute, which is in charge of digital currency development and testing, was inaugurated in 2017, when it invited major state-owned commercial banks and other influential institutions to help design the DCEP system.

In December 2019, the institute’s head, Mu Changchun, said the new sovereign digital currency would be “a digital form of the yuan”, there would be no speculation on its value, and it would not need the backing of a basket of currencies, according to the official Shanghai Securities News.

How is China’s sovereign digital currency different from a cryptocurrency like bitcoin?

China’s digital yuan is managed privately by the PBOC under a centralized system, which is the complete opposite of most other forms of cryptocurrencies that are designed to disperse power away from the government.

Widely-traded virtual currencies, such as bitcoin,  operate under a public, decentralized computer network based on blockchain or distributed ledger technology, existing outside the control of a central authority. Individual holders of the currency are the ones that verify the increase and distribution of the digital money as well as its transactions, rendering them immune to government interference.

But bitcoin, along with many of these cryptocurrencies, faces criticism for being vulnerable to illegal activities and volatile trading prices.

The DCEP system does not use blockchain technology, increasing the PBOC’s presence in the financial system and the risk of political interference. Theoretically, the greater power given to the PBOC by the DCEP would allow it to have more control over the total volume of money supply according to economic conditions.

DCEP, though, operates through a two-tier operating system. The PBOC issues the DCEP to commercial banks and other commercial operating agencies without using blockchain, but the lenders and other agencies are allowed to use the technology to distribute the digital yuan to the public.

More information on business activity would be generated in real time to help the PBOC maintain the stability of the value of the yuan and regulate boom and bust cycles of economic activity more effectively, damping the risk of credit bubbles in the financial system, analysts argued.

The revised proposal in April for Facebook’s planned digital currency, Libra, to include embedded supervision highlights the need to give up on a fully decentralized design to have a chance of winning regulatory approval.

Authorities around the world are concerned that Libra would leverage Facebook’s massive user base, resulting in the creation of a de facto global private central bank and reduce the monetary autonomy of existing central banks, said Raphael Auer, principal economist in the monetary and economic department of the Bank for International Settlements.

Instead of a single token based on a basket of currencies introduced in its initial white paper, Libra’s revised proposal will create multiple units tied to existing currencies such as the US dollar or the euro, which can blend in much easier in domestic monetary, financial and regulatory frameworks, and do not pose direct threats to monetary autonomy, Teunis Brosens, lead economist for digital finance and regulation at ING Bank said.

When will China’s sovereign digital currency be launched?

China has not announced an official timetable for the official launch of its DCEP system, but speculation is mounting that it will be offered to the public in 2020.

The first look of the planned digital currency emerged in April when a screenshot of a test version developed by the Agricultural Bank of China was leaked.

Trials of the digital yuan are set to begin in May in four cities – Shenzhen, Suzhou, Chengdu and the Xiongan zone near Beijing – which will later be expanded to pilot programmes at the venues for the 2022 Winter Olympics in Beijing and Hebei’s Zhangjiakou.

The tests and trials of the digital yuan will be made in small transactions and conducted in “closed environments” that will not affect the commercial operations of the companies involved.

 

The first look of the planned digital currency emerged in April when a screenshot of a test version developed by the Agricultural Bank of China was leaked. (Picture: Handout)

But the Digital Currency Research Institute of the People’s Bank of China stressed that these test versions and applications were not final and did not “mean that China’s sovereign digital currency is officially launched”.

Foreign consumer brands including US chains Starbucks, McDonald’s and Subway were named by the PBOC as participants in the pilot programme, along with Ant Financial, Tencent and 19 local restaurants and retail shops.

Under the trial, Communist Party members will also be allowed to pay their membership fees in digital yuan with one unnamed state bank, local media reported.

In Suzhou, the digital yuan would be used to pay half the travel subsidies to public servants.

What is next for China’s sovereign digital currency?

Xu from Peking University's Digital Finance Research Cen­tre said upon completion of the internal testing, the digital yuan could be gradually expanded for the payment of staff wages at major government departments, administrative institutions, and even state-owned enterprises.

Nouriel Roubini, a professor of economics at New York University's Stern School of Business, said the main problem, however, with the potential success of central bank digital currencies would be that they could disrupt the current system of traditional banking business of taking deposits to use the funds to extend loans.

Individuals and businesses that increasingly use central bank digital wallets to make payments would have less need to deal with commercial banks that may lead to the disappearance of bank deposits, and thereby crimping commercial lenders’ ability to extend loans, he said.

Xu said as China transitions into a cashless society, the need for ATMs in the future would also be questioned, and entire financial facilities and business forms would undergo great changes. Young peo­ple, more familiar with the use of mobile devices, are also expected to take the lead in the usage of the digital yuan.

The development of the digital yuan could resemble the evolution of Yu’e Bao, one of the world’s top money market funds that is distributed on Ant Financial's payment network, Xu said. In the future, users may be given the option to use the digital yuan to make interest-bearing deposits and invest in wealth management products.

Citic Securities estimated the total size of China’s digital currency could reach 1 trillion yuan (US$140 billion) over the coming years, equivalent to digitalising around one eighth of China’s cash. In comparison, the total market capitalization of cryptocurrencies, including bitcoin, is around US$200 billion.

Alibaba is the owner of the South China Morning Post.

(Abacus is a unit of the South China Morning Post.)