Lazard Insights
Beyond Cash: China Pulls Central Banks into the Digital Currency Race
Aristotel Kondili, Director, Portfolio Manager/Analyst
The now ubiquitous Bitcoin and a number of other Summary cryptocurrencies are creating a decentralized, alternative global • China’s digital currency could be a significant financial system. For many investors, the rise of alternative step in the movement of the Chinese economy currencies represents an opportunity for speculation and raises toward a cashless society. interesting long-term questions: Will cash go extinct—and when? • The world’s major central banks, although behind the People’s Bank of China (PBoC), will Central banks, however, are looking well beyond this. The likely introduce digital currencies designed to potential for currency to become decentralized over time could meet their own objectives over the next several interfere with their ability to achieve their core goals: price years. stability (controlling inflation) and maximum employment, which • With digital currency, the PBoC can gain insight into consumer behavior and the full scope of combined can lead to healthy economic growth. If a significant economic activity, including illegal transactions, portion of the population were to use alternative currencies, potentially leading to better policy decisions. monetary policy—from easing financial conditions in a recession • Central bank digital currencies should help to raising the policy rate to fight inflation—could lose much of its improve financial inclusion in China and effectiveness, which has implications for everyone. eventually globally, leading to a reduction in the informal economy. Hoping to push back against the competition, central banks are investigating what it would take to launch their own digital Lazard Insights is an ongoing series designed to share value- currencies—centralized, backed by equivalent assets, and added insights from Lazard’s thought leaders around the world and is not specific to any Lazard product or service. supported by the power of sovereign governments. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed The People’s Bank of China (PBoC) has firmly taken the lead. It via www.lazardassetmanagement.com/insights. tested a central bank digital currency (CBDC) with commercial banks in China last year, and we expect it will officially launch its digital currency soon. Other central banks have published 2 research, done policy work, and floated initial proposals, but progress toward an actual digital currency has been very slow. Digital Currency Primer Nevertheless, spurred by China’s progress, other major central banks will almost certainly introduce their own digital currencies Q: What is a central bank digital currency (CBDC)? in the coming years. CBDC is a digital payment instrument, denominated in the Why Would a Central Bank Want a national unit of account, or currency. It is a direct liability Digital Currency? of the central bank. This new form of digitized sovereign currency will be equal to physical cash or reserves held at In a recent Bank of International Settlements (BIS) study, almost the central bank. all major developed markets central banks, including the European Central Bank (ECB) and the US Federal Reserve, shared their Q: How does it differ from cryptocurrencies, such as plans for and views on digital currencies. The study found that Bitcoin, or stablecoin, such as Facebook’s Libra? some 80% of central banks are investigating digitalization and about half have progressed past the conceptual stage. Bitcoin is not issued by a central bank or typically considered legal tender; it is not a liability of any institution, and it is not The report also found that the primary driver for central banks is backed by assets. Its value often fluctuates with extreme to enable broad access to central bank money: In places where cash volatility. Corporate digital currency projects, such as Libra, usage is in decline, local banking networks may shrink accordingly, leaving households and businesses at risk of losing access to risk- are backed by corporations, such as Facebook. These free central bank money. Some central bankers consider it an currencies are typically backed by an asset reserve of the obligation to provide this access to the public; a CBDC would corporation and can be less risky than cryptocurrencies as a serve as a digital bank note, fulfilling this obligation. means of payment.
Central banks’ second motivation is to retain and even enhance Q: How would a CBDC work at the retail level? the impact of monetary policy, according to the BIS report. If a significant portion of a population uses money that is not CBDC would constitute the first digitized form of central denominated in the sovereign currency, central banks’ ability bank money that the general public could own. People to support financial stability may be limited. Digital currencies would have accounts of the digitized fiat currency with the backed by large private institutions with deep pockets are of central bank or hold CBDC on mobile devices, prepaid cards, particular concern. Facebook’s Libra, for example, is a digital asset or other forms of digital wallets. built by Facebook and powered by a new Facebook-created version of blockchain. Easy access to private stablecoin like Libra, which is Q: What are the main benefits for people who use backed by reserves and designed to maintain price stability, could CBDCs? potentially undermine the role of a national currency, and worse, Using China as an example, in regions with low-to-no undermine confidence in it (Exhibit 1). access to banking services, such as regular credit, cash With their own digital currencies, central banks see a possible still plays an important role. Digital currency issued by path to retaining the strength of their sovereign currencies. For the central bank could bring much of this “underbanked” one thing, digital payments should be safer and more efficient population into the financial system, and theoretically than cash. But also, electronic transactions can provide the central everyone would be able to have access to digital money banks with real-time information on consumer and business and the associated financial services that this would make spending—specifically prices—something they lack now. Seeing possible. (continued on next page) transactions as they are happening could help the banks more accurately target monetary policy to achieve their objectives, especially on inflation. 3
Exhibit 1 Digital Currency Primer (continued) Comparing Major Digital Currencies
Digital Renminbi Libra Bitcoin Q: What are the benefits for central banks and governments? Digital currency would allow broader visibility of money flows in the ecosystem. Some policymakers have expressed concern that alternative currencies could nt n displace the domestic currency in an economy and create Type igit n t in t n s n i nt i significant risks to financial stability and monetary policy. Issuer hin ss i ti n n t The goal for the People’s Bank of China (PBoC) is to gain i t n h in transparency and control on money supply and capital Status i In nt In s sin flows. Additionally, China has a long-standing aim to Primary ns ns sage h s s h s s ti n internationalize its currency. The digital renminbi may help Value I nti t gg t ti with this initiative, making it easier for consumers and Determination n in i n i s t businesses in some other countries to use its national Blockchain sage i it s g nt i nt i currency. As of 31 December 2020 Q: Switching to digital currency will be a big change for Source: China Power many consumers, but how will it be different for central banks? (M0) and a direct liability of the central bank. In other words, Central banks today move and store large amounts the DC/EP will constitute a third form of central bank money, of money electronically, so from a purely logistical alongside physical cash and reserves. perspective, digital currency would be similar. In fact, The structure of the program is fairly straightforward. The PBoC the expense of issuing and managing cash falls mainly will issue DC/EPs to commercial banks against cash or reserves to commercial banks, businesses, and households. For deposited at the central bank. The banks, in turn, will issue DC/ central banks, the differences with digital currency lie in EPs to the general public. The public users will download digital wallets to store their DC/EP funds, and the wallets will generate a the direct link to end users—through the electronic trail code that can be scanned to make purchases at payment terminals. of transactions and possibly through direct accounts with consumers. For example, currently central banks are Because the DC/EP is designed to replace cash in circulation, aware of how much money is in circulation, but they do commercial banks will have a role in distributing the digital not know where it is stored and by whom. Central banks currency to users, meaning that the PBoC will not disintermediate are also missing out on information about everyday cash them for now. Banks must deposit exactly the same amount with the PBoC as the DC/EPs they distribute. So unlike alternative transactions and spending that could potentially help them currencies—which can be very volatile—the value of one DC/EP assess monetary policy more accurately. will always be 1 renminbi (Exhibit 2). While the structure seems simple enough, the technology will not be. In replacing cash, the underlying system needs to be resilient, China’s Initiative: How a Central Bank available at all times, flexible, secure, and private. Given the Digital Currency Works Chinese government’s prioritization of digital currency, its features China was the first to heed the wake-up call from alternative are likely to be superior to third-party payment systems. For currencies. The PBoC has been working on its digital currency/ one, as a direct liability of the PBOC, the DC/EP will enjoy the electronic payment (DC/EP) since 2014 but released few details backing of the government, while other digital payment systems until last year, when it began testing in various cities, including carry the default risk of their corporate parents, even if that risk is Shenzhen. The DC/EP is a digital alternative to bank notes and low. In addition, with support from the government, the PBOC therefore both a component of the country’s liquid money supply has the ability to ensure the DC/EP is more widely used than 4
Exhibit 2 Exhibit 3 Volatility: Cryptocurrency Bitcoin vs. Fiat Currencies and Gold Nearly 85% of Chinese Payments Are Digital
ti it i i ns
it in hin s n in i Int n t s s i Int n t s s n in nt s s i nt s s As of 31 December 2020 The 30-day price volatility equals the annualized standard deviation of the relative price change for the 30 most recent trading days’ closing price, expressed as a percentage. Source: Lazard, Bloomberg Payments as % of online users
competing digital currencies. For example, all online and offline merchants could be required to accept the DC/EP; also, the DC/ Payments as % of mobile users EP could be enabled with near field communication (NFC)— contactless communication between electronic devices like smartphones—a more reliable technology for transactions than the Internet, which third-party payment firms use. As of 31 December 2019 China’s Many Motivations Source: CNNIC China’s digital payment ecosystem is already one of the most advanced in the world. Mobile chat and payment apps in China central banks considering digitalization, only China’s has cited this now have hundreds of millions of active users and provide as an objective. them with access to a wide spectrum of financial services—from payments to savings products. In fact, approximately 85% of That said, another goal for the PBOC should not be underestimated: transactions in the country originate with some sort of digital financial inclusion for the “underbanked” portion of the population, payment, up from 54% in 2012—meaning only 15% of who have little access to credit and still use cash to a large extent. A transactions currently involve cash (Exhibit 3). survey by the World Bank in 2017 found that Asia has the largest percentage of the unbanked adult population globally at 49%, So why is China so eager to launch its own digital currency? Like followed by Africa at 25%. The two countries with the largest other central banks, the PBoC is concerned about the potential for populations, China and India, have 12% and 11% of the global alternative currencies to undermine the national currency, but it unbanked population, respectively. Bringing more people in has other, unique objectives as well. underdeveloped areas into the financial system could not only benefit First, even though China has granted third-party payment licenses them but also reduce the informal economy in China, allowing the to more than 270 companies, the online payments market has government to see the full scope of economic activity. been dominated by the top two players: Alibaba’s AliPay with Unlike cash transactions, digital money will leave an electronic a 52% market share and Tencent’s TenPay with a 37% market trail. Therefore, the PBoC will be able to establish the locations share. Each has the potential to rapidly establish a dominant and, if needed, the parties involved in transactions, which could position by leveraging its large user base and network. Therein lies help the PBOC uncover illegal activity, including capital flight. a major motivation for the PBoC: to challenge this duopoly and China does not allow free cross-border capital movements, and prevent a monopoly from developing. It is noteworthy that of all capital flight happens frequently, creating a substantial challenge 5
Exhibit 4 Exhibit 5 Chinese Cross-Border Payments Are Near an All-Time High Chinese Renminbi Has Become a Slightly Larger Component of Global Currency Reserves World Currency Composition of Official Foreign Exchange Reserves 100
0
60
40
20 0 hin t n issi n in t h i ts h nts 201 1 201 2 201 3 201 4 2019 1 2019 2 2019 3 2019 4 2015 4 2016 1 2016 2 2016 3 2016 4 201 1 201 2 201 3 201 4 2020 1 2020 2 2020 3
As of 31 December 2020 Claims in US dollars Claims in Australian dollars Source: Lazard, Bloomberg, SAFE Claims in Euro Claims in Canadian dollars Claims in Chinese renminbi Claims in Swiss francs Claims in apanese yen Claims in other currencies for the PBOC in setting monetary policy. It occurs in various Claims in Pounds sterling Unallocated Reserves ways, but one of the most common is the manipulation of invoices As of 30 September 2020 by Chinese companies trading internationally, resulting in Source: Lazard, Currency Composition of Official Foreign Exchange Reserves transfers of money abroad. The DC/EP electronic trail could help (COFER), International Financial Statistics (IFS) by capturing information on cross-border fund flows, which are inherently complex and now near their historical high of around more common across China’s borders, they could be settled in 40% of total payments and receipts (Exhibit 4). The rise in cross- renminbi rather than dollars. border flows in recent years, mostly through capital accounts, is also associated with the seemingly large errors and omissions in China is expected to offer its trading partners in Africa the China’s official balance of payments, and these would potentially opportunity to test its DC/EP. Many African countries do not be reduced. have fully convertible currencies, and mutual trade is frequently settled in US dollars, which can be expensive. With its strong Importantly, the PBoC will also be able to use transaction geopolitical influence in the region, China could aim for African information in aggregate on an anonymous basis to see trends in countries to use the DC/EP not only in their trade with China, the economy as they develop. For example, the central bank could but also for their own domestic transactions. Extending that use real-time big data generated by DC/EP transactions to better further, one could envision China leveraging its Belt and Road understand consumption and credit growth at the peer-to-peer Initiative to promote settlement in renminbi, which ultimately, level. Equipped with aggregated data, China could in the very if all the pieces fall into place, would give the Chinese currency a near future operate with a real-time, on-demand monetary/fiscal bigger role in the international monetary system. Admittedly, such policy mix, even targeting a specific town, district, or area of the a transition would likely take place over a long period, though the country—truly customized monetary policymaking. technological evolution of the DC/EP should almost certainly International Ambitions facilitate it. Most central banks are looking first to design digital currencies Making It Official for domestic users and domestic payment systems. However, It has been about a year since China began test-piloting its China is also interested in the potential for cross-border use, which CBDC, and the official launch is probably close, in our view. The would advance the PBoC’s long-term goal of internationalizing introduction of the DC/EP to the public may be a significant step the renminbi and ultimately increasing its role as a global reserve further toward a cashless society in that country. It should allow currency (Exhibit 5). A large portion of cross-border transactions China not only to maintain sovereignty over its own currency with China are currently done in US dollars, in part because of and public policy but also to compete successfully with alternative the US currency’s dominant position as the world’s largest reserve currencies. currency. However, if cost-efficient peer-to-peer transfers become 6
China has a number of unique motivations for pursuing a digital Defending their sovereign currencies from competition—first currency now. Still, we expect other major central banks to follow from alternative currencies and perhaps soon from China’s DC/ in the coming years with digital currencies tailored to each central EP—has pushed developed markets central banks to enter the bank’s objectives and the needs of its population. ECB President digital currency race, albeit with a delayed start. If China reaps the Christine Lagarde recently said the bank hopes to launch a digital benefits it hopes for, especially the ability to improve monetary currency within five years, while Fed officials are conducting policy by using real-time data, other central banks may well pick studies to determine how digital currency would work best in the up the pace. United States.
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