Is the central bank panic about the PBOC coin justified?

In further reactionary panic to China’s hugely-hyped digital currency advances, the Bank of England announced on Monday that it would be creating a joint taskforce with the UK Treasury to explore the potential of issuing a British equivalent.

As their press release stated:

A CBDC would be a new form of digital money issued by the Bank of England and for use by households and businesses. It would exist alongside cash and bank deposits, rather than replacing them.

The move is likely to magnify perceptions that the West can only meet the challenge emerging from China’s e-currency advances, and the greater efficiencies it is likely to offer users, by following a similar path.

And yet, this is hardly the case. The lack of critical commentary about the setbacks China faces in making its e-yuan system a proper challenger to the dollar are glaring. As too is the lack of proper critical commentary about the huge disadvantages that accompany any system that opts to go full CDBC (or unite with its domestic Treasury on any such action).

In the interests of dispelling some of these myths and balancing the narratives out there, we thought we would cite a few comments from Martin Chorzempa, a senior fellow at the Peterson Institute for International Economics, who recently testified on this “threat” before the US-China Economic Security Review Commission.

Here’s the key extract (our emphasis):

Hype has far outpaced the reality in digital currencies, CBDCs, and China’s digital RMB in particular. Cryptocurrencies like Bitcoin are booming, but these are mostly for speculation, as they are ill-suited to large volumes of payment transactions. We are still at an early stage in which the benefits of CBDCs have not yet been proven in practice, and the risks (cyber, operational, financial) are serious enough that most central banks will be hesitant to issue any until these can be resolved with a high degree of certainty. China’s eCNY efforts have similarly yet to prove they will be any cheaper, more efficient, more private, or more convenient than the existing domestic and international payment systems. Therefore, it is unlikely to represent any more a threat to the dollar’s international dominance than the current forms of RMB, at least over the short and medium term. Nothing is certain over the long term, however, so the US should continue to carefully monitor China’s CBDC efforts and other digital currency innovations and incorporate any useful lessons to ensure that dollars and the payments systems that carry them remain competitive long term.

The important context is that for the large part, the Chinese state, allowed fintech companies like Alibaba-affiliated Ant Group and Tencent-owned WeChat to grow into overly dominant bank-like entities that serviced both financial and commercial activities. This is because it suited their interests to modernise the financial landscape and to drive mass adoption of digital cash systems. It made strategic sense to temporarily allow these entities to undercut the far more heavily regulated state-owned financial sector.

Left unchecked, however, these private entities soon became so powerful and so prone to exploiting international regulatory arbitrage they became ever more confident of their ability to deny Chinese government data requests about their clients.

This was obviously going to introduce a power struggle.

When the People’s Bank of China acted in 2018 to force these entities to bring customer deposits onto the central bank balance sheet on a fully reserved basis, it became evident the good times were up. From this point on the fintechs would have to tow the government line or see their exceptional allowances vis-a-vis banks extinguished.

Unsurprisingly, in no time at all, the framework began to clip away at the capacity of the fintech giants to compete with state-owned financial institutions, especially with respect to credit creation.

But rather than recognising the degree to which his fortunes were built on state-permitted financial arbitrage in the first place, Alibaba founder Jack Ma saw fit to vent his frustration in a now infamous October speech, in which he criticised excessive government regulation. Why he thought this would encourage a change of heart by the government is the puzzle.

The government predictably used the criticism to initiate even stricter regulations around privacy, anti-monopoly and financial risk, all of which contributed to the cancellation of the Ant Group’s planned IPO.

In the months since, Chinese authorities have moved to up their control of Ant Group even further by forcing a restructuring of the group into a fully-licensed bank-holding company. The power struggle with Ma also continues.

On Monday, Reuters reported Ant Group would be exploring options that would see Ma give up his control in the company by divesting his stake in the financial technology company entirely.

According to Reuters:

The company hoped Ma’s stake, worth billions of dollars, could be sold to existing investors in Ant or its e-commerce affiliate Alibaba Group Holding Ltd without involving any external entity, one of the sources with company ties said.

But the second source also with company connections said that during discussions with regulators, Ma was told that he would not be allowed to sell his stake to any entity or individual close to him, and would instead have to exit completely. Another option would be to transfer his stake to a Chinese investor affiliated with the state, the source said.

Any move would need Beijing’s approval, both sources with knowledge of the company’s thinking said.

This is the context that Beijing’s digital yuan ambitions slot into. It is important because it demonstrates not only that e-money use already prevails in China, but also — thanks to recent regulatory action vis-a-vis Ant Group — that the PBOC already largely controls it.

So perhaps the e-yuan push is motivated by technological factors and a desire to leverage new decentralised blockchain technologies? Well no. As Chorzempa identifies, Chinese central bankers have publicly rejected the use of blockchain as a basis for their e-yuan because it cannot handle the transaction volume they anticipate.

So what then is impetus for going ahead with a CBDC, if currency and payments are already digital, the PBOC already has the capacity to obtain data from fintechs it has brought into line and blockchain is not the attraction, asks Chorzempa?

Ultimately, as we have stressed for a long time, it’s all about expanding access to the central bank balance sheet to non-bank entities. But since opening up the balance sheet too much is also a recipe for cost transfer to the government, the road ahead seems focused on a two-tier system where the PBOC authorises and supervises intermediaries, starting with banks.

That again begs the question: how is it really all that different to what we have now?

Chorzempa suggests the only real difference is that the e-yuan, unlike bank deposit money, will not pay any interest on money held in e-yuan wallets, which works in a system where banks can offer attractive interest rates to lure funding. He also believes the PBOC might be inclined to help help mask customer identities details from retailers by using encryption.

But if that’s the model that’s to catch on in the rest of the world — especially one that is already partial to negative rates on bank deposits or short-term government securities — it introduces a hugely destabilising force in the financial system, since it creates a climate where the central bank competes directly with the banks it licenses.

In a negative interest world, this disintermediation risk can only be mitigated by a strict cap on the value of balances anyone can hold as CBDC or by matching the negative rate environment. But to police such a cap, the centralised system would require more information about its users, not less.

In that sense, the true disruptive force being peddled by China isn’t access to a superior payment infrastructure, but rather to a system that can facilitate interest rate arbitrage, and in so doing suck dollar funding away from the Western financial system (at a below market rate) . The other main benefit is then using that well-funded framework to create, in the words of Chorzempa, “an alternative, sanctions-proof set of financial infrastructure and currency arrangements”.

We can see why central bankers might be worried about this since it is a bit of Kobayashi Maru situation. If they don’t emulate the system, dollar-funding could be sucked out of the Western financial system in a feedback loop that depreciates the dollar in favour of the yuan (although there are obviously other factors that come into play, such as trust in the Chinese financial system over more Western ones). If they do emulate, the Western financial system could see their own central banks defunding their own banking network, at the same time as adopting ever more centralised and state-directed practices which — under their own AML/KYC frameworks — would force them into ever greater surveillance of their population.

Either way, the situation benefits China. And neither pathway diminishes the attraction of the sanctioned (i.e. the financially deplatformed) to buy into a parallel financial-network system where their ways are tolerated rather than penalised.

But framing the conversation as a technological challenge is nonsensical. All it does is detract from the very real downsides of overly centralised systems and the true nature of the competition at hand, which is a function of interest-rate arbitrage, the sort of privacy users value more (privacy from the state or from data-mining merchants and other private sector entities), and the question of whether deplatforming is effective at all.