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Why China’s CBDC will succeed, and why it will not

The US is governed by lawyers, while China is governed by technocrats. The two nations’ approaches to blockchain technology and cryptocurrencies illustrate these different compositions/dispositions with a shocking contrast.

Is one superior to the other? You be the judge. Or the history will be.

The US system worked very well in the last three centuries, largely because the lawyers left the business into the hands of the people (and American people did work hard and creatively), and the Chinese system worked very well in the last three decades, largely because the technocrats not only allowed people to do business, but they themselves became business (people who are characterizing today’s China as communism or socialism do not know what they’re talking about).

Now, both systems have come to a critical crossroads, each beset by its own corruptions, each facing its own undoing unless a remedy is found.

In the midst of the present crises, few things speak louder than how the two countries are handling the matter of technological advancements, particularly blockchain and cryptocurrencies, and further in front of all that, Central-Bank Digital Currencies (CBDC).

I wish to discuss a few highlights that are behind the political scene on the China side. The story of the US side will require a different discussion.

Why China’s CBDC will succeed

At present, China clearly leads other countries in the advancement of Central Bank Digital Currencies (CBDC), thanks to its government’s technocratic nature. 

China’s Digital Currency Electronic Payment (DCEP), its version of a CBDC, has gone through fairly large-scale tests and is imminently ready for full launch. The government is promoting the new payment system in a manner that means business and wants people to accept it as the future.

And this has other people worried about the world’s reserve currency status enjoyed by the US dollar.

Although DCEP is only tested internally (domestically) at present, its goal is clearly international. The objective of the internationalization of the RMB is to enhance the power of the renminbi (RMB) in international trading and the global economy at the expense of USD. China expects its trading partners to become increasingly willing to use DCEP (the crypto RMB) as the settlement currency outside of the current SWIFT system.  

China’s motivation to do this needs no explanation. But what are the other countries’ incentives? 

Well, just how outrageously inefficient and expensive SWIFT is, alone, could be a large enough incentive, not even to mention China will certainly provide additional incentives such as preferential exchange rates, fast-track customs, streamlined trade deals, and low-interest rate loans in RMB.

Imagine when the cross-border payment and settlement take only seconds (versus days), with fees many times lower than SWIFT. 

The transactional and settlement advantages of a CBDC cannot be overstated despite its violation of decentralization, the most fundamental principle of blockchain. (On these points, namely “the crypto ‘sins’ of CBDC” and “bearer instruments and instant settlements,” separate discussions are necessary).  

Becoming a settlement currency in international trading is a necessary and big step up to becoming a global reserve currency.

People who sneer at this prospect should be given notice of China’s increasingly dominating role among African and Asian trading partners. The massive Belt and Road Initiative (BRI), despite the tremendous obstacles, works in support of China’s RMB ambition. BRI member nations have about 1.34 trillion US dollars worth annually in trade relationships with China, but less than 15% of the amount is paid in RMB, the remainder primarily in dollars and euros. China is, therefore, highly motivated to entice BRI member nations to use DCEP in their dealings with China.

Why it won’t succeed

However, in the midst of all the concerns or excitement (depending on your perspective), one obvious factor is very rarely considered, and even when it is, it is not given proper weight.

China’s capital control and foreign exchange control policies are fundamentally inconsistent with its ambition with DCEP.  

Both presently and prospectively, China cannot and will not allow free foreign exchange with RMB. This is not about what the policymakers understand but an economic reality. The reality is that there is a fundamental fragility in the Chinese economy, and capital control and foreign exchange control are necessary to cover that fragility in order to let the current system continue without collapsing.  

That fragility firstly lies in China’s real estate market. The total value of Chinese homes and developers’ inventory hit $52 trillion in 2019, twice the size of the entire US residential market. Factoring in the US GDP is about 1.5x that of China, China’s real estate market is three times overweighted relative to the economy than that of the US.

For at least 20 years, the Chinese purchased homes not because they needed space to live but because buying real property has been the surest and most rewarding investment. Housing prices have increased more than 20 times over the last 20 years in tier-1 cities.

And the Chinese know this. There is a strong sense that riding an extremely inflated balloon is unsafe, and many want to cash out and go to somewhere else (not just in a different financial sector within the same economy but in a different economy). This, along with several other factors (corruption, to name one, which would deserve another separate discussion), is why the pressure for capital flight is constantly high.

This is the case despite the fact that China is still one of the most attractive economies in which to make investments today (if one does not understand this seeming contradiction, one doesn’t understand China). 

Many people mistakenly think that, with its big CBDC push, China must be planning to relax capital control and foreign exchange control, or at least is preparing to tolerate more of that.  

Absolutely not. China’s planners are actually hoping to tighten capital control and foreign exchange control further using its CBDC, as clearly evidenced by the new policies released during Chairman Xi Jinping’s visit to Shenzhen this week.

As far as the control over domestic activities is concerned, it might just achieve what China’s planners hope, judging from the way China’s version of CBDC is designed to work.

But the question is, how will this be consistent with China’s ambition to elevate RMB’s global influence?  

It can’t be. 

China’s CBDC is a strongly mutated cryptocurrency but is nonetheless a cryptocurrency. It cannot work without having at least some of the properties of the cryptocurrency, and these crypto properties will make it very hard for China to push it to gain the status of a global currency while at the same time being placed under complete control to prevent free capital flow and foreign exchange.

Consider decentralization. DCEP is going to be centralized. But it cannot be completely centralized as the government would like to, without defeating its original purpose.

There is a simple reason for this. As discussed above, one of the most fundamental attractiveness of CBDC is its potential to become a bearer currency to realize instant settlement, like cash is. This is akin to paper cash property, only with digital characteristics.

Consider the current system in which China exerts very strong capital flow control and foreign exchange control. When a business located in China earns US dollars in a foreign market, the US dollars paid to the Chinese business has to go through the Chinese banking system and is, therefore, completely under the control of the Chinese government. The business cannot really freely use the US dollars it has earned. However, it is different when the business gets paid in cash (i.e., paper US dollar bills) in a foreign market. Because cash can work outside the Chinese banking system, it would be much harder for the government to control. Not that Chinese businesses are actually getting paid (or should be paid) in cash in today’s global trading, but to just illustrate a point. The primary reason why Chinese businesses are not getting paid in cash is not because they don’t want the advantages associated with cash but because it is very cumbersome to manage payments in paper cash, both for the payee and for the payer, especially in large amounts.

But once the system switches to CBDC, which has a cash characteristic but without all its cumbersome physical nature, the situation will be different.

Facing that situation, what can China do? If they chop off the instant settlement capability of DCEP, it will negate the very reason why the new system would be attractive to foreign trading partners in the first place, but if they keep the instant settlement capability, they will lose control.  

My prediction is that China will create, or at least will try to create, two different classes of DCEP wallets: first class for foreign trading partners and second class for its own citizens. 

But this is going to be much harder than controlling the current Internet as China has done in the past, not only because it would create a terrible appearance of China discriminating against its citizens, but also, perhaps more importantly, technically much harder to implement.

Internet access can be controlled in a way China currently does because it can be controlled through the user’s physical location and server locations. But when a Chinese person travels overseas, China can no longer control that person’s access to the Internet. That’s been considered an acceptable trade-off by the Chinese government because it is just some Chinese citizens temporarily getting some information overseas. Most people’s understanding and acceptance of foreign information is very limited and can be further shaped through domestic political and social influence anyway.

But digital wallets are different. Money is money. It is objective, not subjective. When someone can connect his DCEP wallet to the emerging global Internet of Value (IoV), even briefly, the money would be gone.  

The final thought:

Both the biggest strength and weakness of China arise from this commonality: Control. But how long can two forces pulling at two opposite directions coexist? Will China eat its cake and have it, too? Can China promote globalization to its trading advantages while maintaining or even increasing its level of control? I can only theorize and speculate.