To what extent would digital yuan contribute to its internationalisation

In the last Chinese Lunar Year, the People's Bank of China (PBOC) doled out tens of millions of digital yuan among the inhabitants of several cities in China that can be downloaded on their smartphone. These gifts were made in an attempt to trail the introduction of its digital currency.  

Although the current digital yuan project has the domestic focus to promote digital payments inside China, the country is laying the foundation for its possible cross border use. Once digital yuan is scaled up to cross-border payments, some commentators are claiming that it may contribute to the yuan's international visibility. 

The advent of blockchain technology in 2008 has created the platform for the introduction of digital currencies. Over the years, several private digital currencies or cryptocurrencies (Bitcoin, Ethereum, Tether etc.) have gained popularity. 

However, private digital currencies are beyond any regulatory ambit, so they are subject to high volatility which may engender a sudden loss of asset value. It can also contribute to the proliferation of illegal activities like gambling, terrorist finance, money laundering. 

Because of these drawbacks, the prospects of cryptocurrencies are believed to be uncertain. Conversely, central bank-backed digital currencies have many prospects. It can help users to sidestep financial intermediaries like banks - giving users the advantage not to pay bank charges and enable a regulator to track payments easily. 

In the last Chinese Lunar Year, the People’s Bank of China (PBOC) doled out tens of millions of digital yuan among the inhabitants of several cities in China that can be downloaded on their smartphones. Photo: Reuters

Given the irresistible temptation of technological novelties and several perceived advantages, many central banks across the world have decided to introduce their digital currency and embarked on cooperation for their trails. The PBOC is one of the frontrunners in trailing the feasibility of a digital currency. 

Over the last four decades, China has achieved phenomenal economic success making it the largest economy in the world ($17.632 trillion) in terms of purchasing power parity surpassing that of the US ($17.416 trillion) in 2014. As per 2018 statistics, it is also the largest exporter of the world accounting for a 13.45% global share where the corresponding figure of the US is 8.98%. 

Although international currencies are the mediums for facilitating cross-border trade and financial investments, China's share in the ladder of international currencies is still at the bottom.  According to the IMF, the share of the US dollar in the global reserve currency is 60.34% where the share of yuan is only 2.13%. 

According to SWIFT, in 2017 the US dollar was used in the highest volume (38.9%) as a vehicle of interbank cross-border payments followed by euro (35.7%), pound sterling (7.0), yen (4.0%) and yuan (2.0%).

The Global Financial Crisis (GFC) in 2008 created much concern about the future appeal of the US dollar. Many were apprehensive about the imminent devaluation of the US dollar. It was a big concern for China as it held around $1 trillion investment on US Treasury Bills and considerable dollar-based reserves by the end of 2009. 

In this context, PBOC's Governor Zhou Xiaochuan questioned the validity of the dollar-dominated international monetary system. Eventually, China formally started internalisation of yuan in 2009 to tarp the advantages of avoiding exchange change risks and securing itself from any collapse of the dollar-dominated international monetary system.  

Since its pronounced internationalisation, the yuan has registered slow but steady progress at the global stage. Despite that, its global standing has been relatively low as reflected in its position in the international reserve currency status and cross-border interbank transfers. Experts blame the underdeveloped financial market and capital controls pursued by China as well as foreign investors' low confidence in its institutions. 

As part of the yuan's internationalisation efforts; over the years, Chain has taken several cautious steps to attract investors to its financial market. China introduced onshore panda bonds in mainland China in 2005 to encourage domestic and foreign investors to invest in yuan-denominated (CNY) bonds or assets. 

As of 31 October, 2020; despite offering a relatively high yield, its onshore bond market ($11895 billion) occupies the third position in the world, next to those in the US ($27267 billion) and Eurozone area ($15367 billion). And, issues are that the size of its onshore bond market is far below than that of the US and foreign investments in its onshore bond market are only 4% ($400 billion).

It also introduced dim-sum bonds in 2007 in an off-shore location in Hong Kong to encourage foreign investors to invest in yuan-denominated bonds or assets. The dim sum bond reached its peak in 2015 with 580 billion yuan ($95 billion), but it is considered quite low by any international standard. 

For low foreign investments in the onshore bond market of China, experts also blame strict capital controls China has been pursuing to deter foreign investors from taking money out of the country. However, in 2018 and 2020, China eased some restrictions on capital outflows by abolishing certain quota, repartition and lock up periods. However, their efficacies can only be judged as time passes. 

Another issue is that institutions in China are perceived to be weak. China being a one-party state, foreign investors have some misbeliefs on the independence of its institutions especially on its Judiciary and its state-sponsored capitalism. Resultantly, investors doubt that they may not get impartial judicial redress on any disputes where their state interests are intertwined. 

It is worth noting here that Cornell University Professor Eswar Prasad in his book The Dollar Trap claimed that despite all the misgivings on the future appeal of the dollar after the GFC, investors did not turn away their attention from dollar-denominated assets because of the independent nature of US institutions.   

As China has become a leading trade and investment partner for many countries across the world; evidently, we can also expect that its digital yuan would be widely used for cross border payments. And, China may trap this opportunity well as it would be far ahead compared to its competing countries in introducing a digital currency for cross border payments. 

However, unless a currency can ensure its store value, foreign investors and central banks across the world would be less likely to keep the currency. Here lies the importance of a well-developed financial market, ease in capital controls and robust and independent institutions.    

Renowned monetary economist Benjamin Cohen once said 'great powers have great currencies. As China is advancing fast in becoming a great power, the digital yuan may help it to have a great currency at some time in the future. 

But, Yuan's international use with a deserving share at global stage would largely depend, not only on the introduction of digital yuan but also on China's policy move to liberalize its financial market, ease capital controls and build robust institutions on which foreign investors and central banks across the world can harbour their confidence high.  

The author studied International Political Economy at Nanyang Technological University, Singapore. He can be reached at [email protected]

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.