Financial Markets

Central banks are gradually warming to digital currencies

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Author: Alex Katsomitros


March 5, 2021

Last April, amid the COVID-induced panic that engulfed the planet, more shocking news came from China. The People’s Bank of China (PBOC) announced that it would start testing its own central bank digital currency (CBDC), a first for a major economy. Government employees in four cities were paid in digital yuan, while four commercial banks began internal tests. By December, around 50,000 lucky citizens had received 200 e-yuan (£23) in their digital wallets to spend on apps such as the food delivery service Meituan Dianping. A new era had started.

A change of heart
It has not always been like that. When Bitcoin, the first cryptocurrency, appeared in 2009, central banks disparaged it as a fad, a dud, or even a fraud. Many banned its use. In 2013, China barred its banks from using it as a currency, citing concerns over financial stability. The same year, Paul Krugman, perhaps the world’s most famous economist, penned an op-ed entitled “Bitcoin is evil.”

Gold-backed sovereign digital currency offers a compelling solution to slowing economic growth and rising inflation that many markets around the world are experiencing

Fast forward to 2021, and the mood music has changed. Central banks around the world set up working groups to discuss the merits of CBDCs. A survey by the Bank for International Settlements (BIS) found that most developed economies are considering the idea. International organisations like the IMF weigh the pros and cons of a novel financial architecture dominated by CBDCs. The Bank of England has released a roadmap leading to a digital pound sterling, a prospect that could help the UK’s COVID-stricken economy benefit from negative interest rates, according to Andy Haldane, the bank’s chief economist.

As for the US, it is grudgingly joining the party, with Treasury department and Fed officials openly discussing the possibility of a digital dollar. One reason for this Damascene conversion is that commercial banks have embraced the blockchain, the technology underpinning cryptocurrencies, with leading banks such as JPMorgan Chase using it for cross-border payments and settlement. “What has spurred interest in CBDC issuance is the realisation that it offers a holistic solution for updating financial infrastructure and enables instantly settled payments at no cost to customers,” said Josiah Hernandez, head of the CBDC Group, a think tank specialising in sovereign digital currencies. One such venture is Project Ubin, a project designed by Singapore’s central bank that aims to provide a global payments platform for central banks.

Elvira Nabiullina, governor of Russia’s central bank

Sovereign digital currencies have also moved up on the agenda of political leaders, with G20 finance ministers contemplating the need for a global regulator to lay down the law in the Wild West of cryptocurrencies. G30, an influential group of central bankers and academics, advises policymakers to take action before rogue players do it first. Countries like Venezuela and North Korea are already using cryptocurrencies to push their agendas. The former has launched its own digital currency, aptly named the Petro, to bypass US sanctions. The Russian government is also considering issuing its own CBDC, backed by gold. Elvira Nabiullina, who heads the country’s central bank, has said that it could be used to settle trade transactions with other countries. In the current climate of debased fiat currencies, stablecoins, namely digital currencies backed by stable assets, are emerging as a safe asset. “A gold-backed CBDC offers a compelling solution to slowing economic growth and rising inflation that many markets around the world are experiencing,” Hernandez said.

Replacing physical cash
Another reason why central bankers are warming up to CBDCs is the slow but steady adoption of cryptocurrencies by the public (see Fig 1). Initial coin offerings (ICOs), once seen as a scam, are becoming a mainstream method for start-ups to raise capital. By late November 2020, the total market capitalisation of crypto assets stood at £476bn. COVID-19 has also boosted the use of digital cash, with digital payments becoming the norm. “The pandemic has led to an increased focus on digital cash to replace contaminable physical cash, in addition to creating more reliable, effective, and optimised mechanisms for the distribution of [COVID-19] relief funds. This led central banks to prioritise CBDCs,” Hernandez said.

Not surprisingly, it was a technology company that kick-started the race. In June 2019, Facebook announced the launch of its own digital currency, Libra. The project’s white paper stated that CBDCs could be integrated into the Libra network, sparking fears among central bankers that a private company would compete with them in their own game.

In a dramatic testimony to Congress last July, Mark Zuckerberg warned US policymakers that if they didn’t endorse Libra, China would move first. Chinese officials took notice, worrying that the yuan would not be included in Libra’s currency basket, amid a trade war with the US. “China’s trials have accelerated as a result of Facebook’s attempt to introduce Libra, even as the PBOC had been conducting research on a CBDC for many years,” said Dylan Loh, a China expert who teaches at the Nanyang Technological University in Singapore.

China first
Many interpreted China’s announcement last spring as a part of its distraction tactics amid the global furore over the pandemic, which allegedly started in Wuhan. However, it was far from a spontaneous move. Xi Jinping, the country’s president, had announced the launch of e-yuan on October 24, 2019, a day the government has named “China Blockchain Day.” Relevant infrastructure was long underway, culminating in the launch of a blockchain-based service network that can support applications in various fields, from healthcare to insurance.

Unlike other digital currencies, the e-yuan is not a cryptocurrency, nor is it based on blockchain technology. As a centralised currency, it will be issued by the central bank and circulated through China’s network of state-owned banks. Although China is gradually becoming a cashless society, it has no plans to ditch banknotes and coins. Users will be able to turn their deposits into tokens stored in digital wallets.

Domestic considerations have played a role. Government officials hope that a digital yuan will reduce transaction costs, facilitate cross-border payments and include China’s 200m unbanked citizens in the financial system. Some also point to a covert plan to rein in the country’s most popular payment services: Alipay (owned by Alibaba) and WeChat Pay. The government is imposing tougher antitrust rules on Chinese tech powerhouses, including the e-commerce giant Alibaba. Merchants will be able to use the digital yuan for free, whereas commercial payment systems charge a fee. “These two companies control 96% of the Chinese mobile payments market, and have been allowed to operate in a lightly regulated fashion thus far. Fiat money in digital form will likely result in a more resilient multiplayer financial ecosystem,” said Professor Michael Sung, Co-director of the Fintech Research Center at Fudan University.

Control via blockchain
In a country where the tight grip of the state rarely loosens up, the launch of a sovereign digital currency has raised concerns over privacy. Many believe that China hopes to stem capital flight, a problem that has worsened over the last decade, despite strict capital controls. A report published last August by the blockchain firm Chainalysis found that Chinese citizens had moved $50bn in cryptocurrency out of the country within just 12 months. The digital yuan could be incorporated into China’s notorious social credit system, which rewards citizens for good deeds such as donating blood or punishes them for defaulting on loans or jaywalking. “Cryptocurrencies demonstrate a new opportunity for states to incorporate their values and ideology into money, whether that’s monitoring people’s behaviour or how they spend their money,” said Olinga Ta’eed, a blockchain expert who teaches at Birmingham City Business School and is a member of China’s e-commerce Blockchain Committee. He added: “China never had any problems about saying this. They openly admit that there is some degree of control.”

Sidestepping sanctions
However, China’s plans could be even more ambitious. A CBDC used beyond China’s borders could consolidate the yuan’s position as a reserve currency, as Yi Gang, governor of the central bank, has implied. As a result, America’s most powerful weapon, the dollar, would lose some of its appeal. “There could be a ‘dollarisation’ effect across Asia for the yuan due to increased access through digital issuance and the strong trade and lending activity the country maintains in the region. This could lead to less dependence on the dollar in the region and other markets with similar ties to China,” Hernandez said. “China seems to be approximately five years ahead,” said Philipp Sandner, head of the Frankfurt School Blockchain Center at the Frankfurt School of Finance & Management.

He added: “If a country successfully launches a CBDC or a private payment system, such as Libra, is used heavily, it can change international capital flows substantially. Therefore, the dollar, as the most prominent reserve currency, could lose its dominance.”

A case in point are US sanctions. In a meeting of the BRICS countries in 2019, policymakers and executives from Brazil, Russia, India, China and South Africa discussed the launch of a common cryptocurrency as an alternative to the dollar. Such a system would help these countries skirt the international payment mechanism SWIFT, through which the US imposes sanctions on rogue states. “Having a CBDC and allowing other regional actors to plug their financial system into this infrastructure will help China reduce its reliance on the SWIFT payment system and thus reduce the costs of US sanctions,” Loh said.

Chinese media have reported that the government has considered the launch of a gold-backed token on the back of the country’s position as a leading gold exporter and its access to gold reserves elsewhere through its Belt and Road Initiative (BRI). China could force participant countries to accept loans in digital yuan to boost its adoption. “I have no doubt that China will eventually roll this [the digital yuan] out nationally. Once this is done, and teething issues are addressed, it can look forward to blending this with its BRI programme,” Loh said.

Europe lagging behind
Europe is watching the latest developments in Asia with consternation. The Eurozone recently came out of an existential crisis, culminating in the Greek referendum, and is now entering a period of uncertainty due to the pandemic. Many think that launching a digital euro would be too risky. For others, it seems inevitable. In November, Christine Lagarde, the head of the ECB, said that an e-euro will appear in two to four years, with a decision being expected by the middle of 2021.

Christine Lagarde, President of the European Central Bank

One reason why Eurocrats are suddenly keen on CBDCs is that they sense an imminent threat to Europe’s hard-won monetary sovereignty. “Libra and the Chinese CBDC were a wake-up call for central banks, including the ECB,” Sandner said. Last October, the ECB published a report mapping out possible iterations of an e-euro. One reason why it could be necessary, the report notes, is to assert the “strategic independence of the EU”, notably “if there is significant potential for foreign CBDCs or private digital payments to become widely used in the euro area.”

The main question is whether the ECB will enable ordinary citizens to open e-euro accounts at the central bank, thus bypassing commercial banks. Although endorsed by blockchain enthusiasts, such an innovation would increase funding costs and possibly raise interest rates on loans. The ECB’s balance sheet would also balloon, forcing the bank to acquire assets held against the digital euro. Fabio Panetta, who chairs the ECB’s CBDC task force, has said that the bank is exploring whether its settlement system could support retail depositors. However, most experts doubt that commercial banks would be left out. “They will put a stop to anything they think could be a threat to their core business, even if they pay some lip service to it. Central banks also don’t want the risks and the politics that go with retail accounts,” Ta’eed said.

The end of a dream
If the pandemic proved that borders still matter, the rise of CBDCs confirms the role of the state as a financial arbitrator. Geopolitical tensions had already slowed down financial globalisation, even before the advent of COVID-19. With the rise of insular trade blocs, the era of borderless financial markets might be coming to an end. “It’s ironic that after so many years of hollowing out the state through privatisation and globalisation, it now roars back through CBDCs,” said James Cooper, Professor of Law and Associate Dean at California Western School of Law. One reason why central banks may be keen on digital currencies, Cooper marked, is taxation. “Getting records of people’s financial transactions so there’s a tax basis is important, because the state relies on tax to generate revenue for state activity.”

Cryptocurrencies demonstrate a new opportunity for states to incorporate their values and ideology into money

For the early pioneers of the blockchain, however, this may be a wild awakening. Cryptocurrencies started as a libertarian dream that would free money from the long arm of the state, namely central banks and tax authorities. They may now empower the very Leviathan that Bitcoin’s inventors were trying to bring down. “A great dream often outlives its dreamer,” Hernandez said, pointing to other technological innovations that deviated from their original purpose. For more cynical analysts, such a development was inevitable. “Data is the new currency,” Ta’eed said. “Why else will the central banks support CBDCs, if not to effect some kind of control?”



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