Economic impacts of central bank digital currency evaluated
Visitors test the blockchain ATMs displayed at a high-tech exhibition in Shenzhen, Guangdong Province. Photo: CHINA DAILY
Recently, the news that China will begin a pilot run of its central bank digital currency (CBDC) has drawn worldwide attention. The project makes China the first major economy to carry out a real-world testing of an official digital currency. The People’s Bank of China started research on its digital legal tender in 2014 and rapidly pushed it forward in the last two years.
Most countries took interest in digital currency research around 2017, for three primary reasons. First, the sci-tech advancements make digital currency more technically feasible. Second, the rise of mobile payments has already gradually reduced the use of cash. Lastly, international competition in this field has intensified.
In a survey of central banks in 66 countries carried out by the Bank for International Settlements (BIS) in 2019, over 80% of central banks were engaged in sovereign digital currency projects. Around 40% moved from a proof-of-concept to experimentation programs. One in 10 central banks is expected to offer CBDCs within the next three years.
Technological advancements
According to the BIS, digital currencies issued by central banks can be split into two categories: wholesale digital currency and general-purpose digital currency. While the former intends to support wholesale settlements such as interbank payments and securities settlements, the latter is a general-purpose digital currency that is available to the general public.
From the technical perspective, the wholesale CBDC relies on blockchain technologies to transform the transaction mode from a digital account into digital cash, so as to improve the transparency, security and overall efficiency of payment.
In the meantime, there are two technical options for the general-purpose CBDC. One is to allow the general public to open a central bank digital account, whose balance will be booked as the liabilities of the central bank, so it is a digital form of central bank money. The other is digital cash, which means that the central bank uses cryptographic algorithms to issue and circulate digital currency. Instead of verifying the identity of the currency holder in the transaction, the user only needs to guarantee the authenticity of the digital currency itself, just like the authenticity of banknotes.
In comparison, digital cash still faces certain technical difficulties and requires further technical R&D and related tests to ensure its feasibility, whereas digital accounts run similarly to commercial banks’ current account operation systems, and their technical threshold is relatively low.
The general-purpose CBDC grants residents direct access to central bank funds and provides a digital fiat currency similar to cash, which will have a far-reaching impact on the financial system and macro economy.
Therefore, central banks across the globe have carefully weighed the benefits and costs and come to different conclusions. For example, Riksbank, the central bank of Sweden, believes that the risks of the CBDC are containable and the advantages are evident, so it has started testing its proposed “e-krona.” However, Danish central bank said the potential benefits of introducing CBDC for households and businesses in Denmark would not match the considerable challenges presented by this introduction, so Danmarks Nationalbank has no plans to issue the CBDC.
In July this year, China launched programs to test the digital currency in Shenzhen, Chengdu, Suzhou and Xiong’an and plan to expand the pilot programs to a broader range, with a focus on retail use in the near future. The new digital renminbi, known as Digital Currency/Electronic Payment (DC/EP), will function much like a digital form of cash and primarily operate via smartphones.
The DC/EP will support offline payment, made possible by “near field communication” technology, which represents a big breakthrough compared with online transactions and doesn’t need to be tied to any bank account. In addition, the digital currency may support large-sum payment. Therefore, DC/CP brings with it both technological innovation and the potential economic impact, requiring further in-depth analysis and research.
Potential economic gains
In the discussion of China’s CBDC, a common question appears to be whether it is necessary for the central bank to enter the mobile payment market given that China already has a mature third-party mobile payment system and what the marginal contribution of the CBDC will be. Based on previous studies of China’s central bank and other central banks, the following potential economic benefits are highlighted.
First, the CBDC maintains the monetary sovereignty and legal tender status. In the retail market, cash is the only fiat currency, but it is expensive, inconvenient and the use of paper money is declining. By issuing digital fiat currencies, central banks will contribute to society’s digital revolution.
Second, the central bank-backed mobile payment services are likely to make the market more competitive. The introduction of the CBDC will provide an alternative to third-party mobile payments and limit the power of certain private payment platforms. Unlike private platforms, central banks don’t pursue purely commercial interests, they pay more attention to social effects.
It is worth noting that the direct government participation in competitive payment markets requires fair and coordinated license management, innovation in terms of user needs, and safeguards for current convenient payment environments, to promote social welfare and avoid administrative monopolies in mobile payment markets.
Third, the CBDC may help to keep payment tools inclusive and robust. Current mobile payment platforms rely on mobile network coverage and are difficult to access during natural disasters or in remote and poor areas. Both China and Sweden are exploring the design of offline payment functions for the CBDC, aiming to provide payment services without network or signal and expanding the boundary of mobile payment. However, the Riksbank pointed out that offline payments need to be monitored within regulatory frameworks, limiting the number of offline transactions and the amount of transactions, to reduce risks for the payer and the payee.
Impact on finance
In addition to the aforementioned potential advantages, the CBDC may also have adverse effects on the financial system and macro finance. Financial disintermediation and transnational spillovers are the most discussed of these disadvantages.
There are two types of financial disintermediation which may be induced by the CBDC. The first is periodic financial disintermediation, which means that when financial risk is high, residents may destabilize the CBDC by withdrawing a large amount of their deposits. During a financial crisis, a large number of customers would rush to the bank to withdraw cash, which is called a bank run. In the cash-dominated era, bank runs were carried out by waiting in line at banks. When the CBDC is in circulation, bank runs can occur more quickly and easily through simple mobile phone operations, and are therefore likely to cause greater shocks.
The second possible scenario is structured finance disintermediation. It happens under a normal economy when residents convert large amounts of their current deposits or other payment account balances into the CBDC. This will reduce the funding sources for financial intermediary sectors, increase the central bank’s liabilities to the residents, and thus affect the liquidity supply of financial intermediary institutions, mainly commercial banks, to the real economy, and increase the dependence of commercial banks on the central bank funds.
In order to reduce the possible CBDC entry risk, scholars have proposed various solutions, including restricting the amount of money transferred in and out of the central bank’s digital currency accounts, setting the holding ceiling for the CBDC, and implementing negative interest rates for CBDC’s overholding. However, so far, none of these approaches have managed to gain universal recognition.
The transnational spillover effect refers to the impact that the CBDC of one country may have on other countries through cross-border capital flows. Take Denmark as an example. Its capital account is fully open and its exchange rate system is fixed. Once Denmark issues the CBDC, its legal tender and stable exchange rate may attract investors from other countries. This, combined with the convenience of digital trading, will exacerbate capital flows in Denmark, which is one of the main concerns of the Danish central bank.
Many countries have carried out research on the possible economic and financial impact of the CBDC. The United Kingdom’s central bank has no clear issuance plan so far, yet it publicly called on the academic community to analyze its macro impact as early as 2015, and stressed that the CBDC is not a simple technical tool, but an invention that would affect the infrastructure of the financial system.
As the macroeconomic structure and the CBDC implementation plans vary in different countries, it is difficult for China to directly gain reference from other countries. Therefore, the question of how CD/EP might affect the financial system and how its economic benefits and costs should be measured are not only of theoretical importance, but also of practical urgency. Going forward, we must look for answers based on China’s national conditions and CD/EP design.
Ji Yang and Wang Peng are from the School of Economics at Xiamen University; Bian Wenlong is from Sungkyunkwan University.
Edited by YANG XUE
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