China has been developing and experimenting with a digital yuan, a central bank digital currency (CBDC), with China’s blockchain. China, one of Bitcoin’s biggest opponents, has taken the lessons being learned around the new technology and appropriated it to service its population.

A blockchain is a secured public ledger that tracks every single transaction it makes. A Chinese-backed CBDC and its blockchain would open the door to increased surveillance of every user’s financial transaction. 

China’s CBDC will likely try to solve some of the issues that public cryptocurrencies such as Bitcoin and Ethereum have, like the high cost of capital and energy to conduct transactions. In addition, this control of the blockchain in the digital yuan would also enable the Chinese regime to change many concepts of how cryptocurrencies work. For example, it would be able to fork (change the base code) the blockchain at will or even reverse transactions that weren’t favorable to itself.

Is CBDC a tool for the Yuan to usurp the USD?

According to James Hinote, a Geopolitical Analyst at CJPA Global Advisors, the biggest challenge the digital yuan poses to the U.S. financial system is that it doesn’t need to interact with it. Currently, all bank transactions need to be processed by the SWIFT payment system, a European system transacted in U.S. Dollars (USD). As a result, one of the most extreme sanctions against Russia was restricting its access to the SWIFT system.

Fearing that a similar sanction could affect them in the future, China has been developing alternatives to the system. For example, the digital yuan and its ability to transact without a foreign processor provides an alternative to the Chinese payment system, the Cross-Border Interbank Payment System (CIPS).

CIPS, a direct alternative transacted in yuan to the SWIFT payment system, is another tool of the Chinese regime to increase its financial influence and insulate itself from western sanctions. CIPS performs similarly to SWIFT but lacks the same adoption amongst financial institutions. Nevertheless, in the event of sanctions CIPS may help China transact domestically and abroad in some limited ways.

The growing influence of the Chinese yuan and an independent Chinese financial system can be attributed to the ease of use of their electronic payment systems domestically and abroad. Also, their forward-thinking development of technology and systems doesn’t need to use the U.S. financial system. These efforts challenge the USD as the global reserve currency and may allow China to circumnavigate any economic sanctions from the West.

According to Science Direct, China’s efforts seem less likely to be aimed at internationalizing their currency and more likely to be focused on replacing the dollar as a global currency. In the international monetary system, the RMB and the U.S. dollar work at cross purposes. Therefore, the progress toward RMB internationalization comes at the dollar’s expense. Greater demand for the RMB means less demand for the dollar. In addition, China’s position as the world’s largest exporter gives it an edge over the U.S. in its efforts to internationalize its currency.

China expects to offer its trading partners simplified payment methods based on “digital currency, electronic payment” (DCEP). As a result, direct transactions denominated in RMB can occur without involving a third-party currency exchange (U.S. dollar in this case). 

Conducting transactions in this way eliminates the need to incur the cost of currency exchange, further streamlining imports and exports for China and its trading partners. In addition, the Chinese regime can use its influence in the international market to accelerate the process of dethroning the dollar. 

Financial Times also determined that China’s digital currency threatens dollar dominance.

The question is: Can a currency usurp the throne if it can not be “tolerant” to the whole world but only acts for its own benefit?

USD is ‘tolerant’ worldwide: CBDC acts for its benefit alone

Micheal Pettis, one of the world’s leading economic and financial experts on China, said that the Financial Times’s assessment of CBDC’s ability to usurp the dollar is too optimistic.

Micheal stated that the comment of the Financial Times seems not to have analyzed deeply enough to touch the roots of the reserve currency. It has not taken into account the internal risks of the Chinese financial system, asset bubbles, etc. Bad debt and economic imbalance can destroy the yuan’s strength, weakening the spread of CBDC. That is not to mention the risk of technology vulnerabilities and fake crypto wallets. Fake CBDC cryptocurrencies can cause incalculable harm to the reputation of this currency.

The real advantage of CBDC is just “low transaction costs,” which does not make CBDC a reliable reserve currency.

Low transaction costs are necessary, but it is not nearly enough for CBCD to become a reserve currency. Looking back on history, the reason the USD has become the largest reserve currency in the world is that it not only provided the world with net savings when the whole world lacked money for economic reconstruction (after World War I and II). When the global economy was restructured, and there were net savings, the U.S. could absorb global net savings. The U.S. became a “permanent net absorber of foreign savings.”

Of course, during this time, the U.S. moved from a long-term trade surplus, when the world needed the U.S. to provide food, capital goods, and consumer goods, to a long-term trade deficit, when the world urgently needed somewhere to sell off the world’s abundant consumer goods.

Professor Pettis said that history has proven that a country’s currency becomes the world’s reserve currency when it “accommodates” the whole world, not just because of low transaction fees.

What seems more important when the world chooses a “reserve currency” is the willingness, the ability of the country that owns the reserve currency, to manage a large global imbalance. Thus, the USD has become the number 1 reserve currency in the world, not just because it meets the needs of the U.S. alone but the needs of the rest of the world.

The US Commission on International Relations (CFR) report shows that the U.S. typically absorbs 40-50% of global imbalances. However, anglophone countries—with similar financial markets, all of which far outweigh their weight as international reserve currencies—generally absorb 65-75% of global imbalances.

Given that China’s currency punches so far below its weight, it is surprising that anyone would argue that there is no relationship between the international status of a currency … and its willingness and ability to absorb global imbalances.

Pettis commented that these countries are “willing” to accept major reserve-currency status has more to do with ideology than with economic rationality.

Like the UK in the 1920s, they are perhaps too willing to sacrifice the needs of the producer side of their economies to maintain the overwhelming power of the financial side. The result is that these reserve-currency countries constantly have to choose between allowing unemployment to rise or allowing debt to rise. They have mostly chosen the latter.

Besides, China has been promising for nearly two decades that its currency will achieve dominant reserve status within five years or so. However, the RMB is probably the least important of the top ten currencies, given its position as the second largest economy … and largest trader in the world. Its role has barely improved by relevant standards in the past decade and may even have declined.

As Pettis analyzed, for all the overly excited talk about achieving great international status, Beijing has consistently refused to take economic measures, the necessary step to increase China’s role in absorbing global imbalance. In other words, China is only selfish for its own sake. It has never been for the global good, let alone shouldered the responsibility for global balance.

On the contrary, when COVID-19 created a demand shock in a world already suffering from excess savings and insufficient demand, Beijing had an incredible opportunity to boost the role of the RMB by boosting net domestic demand. Instead, it implemented a muscular supply-side response that worsened its contribution to global demand imbalances.

Concluding his remarks, Pettis expects the dollar’s international position to decline eventually, but not because of the strength of the YEN or the renminbi’s dominance. 

Instead, it will decrease because the U.S. is no longer willing to accept the huge and increased economic costs that the dominant reserve currency status has on its production and the current balance sheet. Or it will decline as the cost of maintaining the currency’s strength increases, and the dollar weakens the U.S. economy, which has always been the source of its strength. 

The UK experience in the 1920s provides a quicker vision of how that could happen.

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