China's Central Bank–Backed Digital Currency Is the Anti-Bitcoin

January 31, 2018 10:00 AM
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The Chinese love bitcoin, but their government hates it. Bitcoin, the digital currency that has taken off as an investment in the last few years, is popular for many of its users because it is neither backed nor controlled by any government, allowing anyone to transfer money around the world, virtually anonymously, by trusting only code. Monetary authorities everywhere are watching the phenomenon with concern. But in China—a country with a long history of limiting investment channels domestically and clamping down on people’s ability to get money out of the country—the appeal to the population and the anxiety for the government is obvious. The Chinese were some of the most enthusiastic adopters of bitcoin, which has allowed them to easily skirt capital controls and transfer money outside the watchful eye of the government. But many consider bitcoin to be disreputable because of its use by criminals around the world to avoid takes and launder money.

China’s government has aimed to reassert control. In 2013, China’s central bank, the People’s Bank of China (PBOC), banned banks from dealing in bitcoin and retailers from accepting it, causing a crash in the price. In 2017, it began enforcing tougher regulation on exchanges that made buying bitcoin easy. It then reversed course by shutting down all domestic exchanges and banning initial coin offerings (ICOs) that created new digital currencies like bitcoin to fund new ventures.

It is proving impossible to completely stamp out bitcoin, even in China, however. Millions of Chinese still possess and trade it, now mostly through overseas exchanges and local brokers that arrange peer-to-peer trades without an exchange. China is thus taking a different tack, hoping to provide its population with an appealing alternative that the government can still control.

The PBOC Announces Plan to Issue Its Own Digital Currency

While the Chinese government views digital currencies it cannot control as a threat, it wants to capture some of their benefits by embracing the technology underlying bitcoin without relinquishing control. The PBOC has been exploring issuing its own digital currency since at least 2014. Ramping up this exercise in 2017, the bank set up small scale experiments with mock transactions between it and commercial banks. But on January 27 of this year, the PBOC went much further into this experiment than many people expected.

In an interview with Yicai, one of China’s leading business news publishers, PBOC Vice Governor Fan Yifei made a groundbreaking announcement detailing the PBOC plan for issuing a digital currency. There will be little to no resemblance to cryptocurrencies like bitcoin. It will remain centrally controlled and aim primarily to replace cash, rather than compete with bank deposits and other financial products. In effect, the plan allows China’s government to use digital currencies to increase control. Cash is virtually untraceable and can be transacted with no records, but the digital version replacing it will have “controllable anonymity.” The plan has clearly made strides not only on the technical side but also in the arguably more difficult process of obtaining consensus in a cautious political system and buy-in of banks. The plan could have a powerful effect beyond China, as other central banks learn from China’s example and ponder their own plans to issue digital currencies.

PBOC Assures Banks Their Future Is Safe

Much of the PBOC announcement focuses on the limited scope of the proposal, surely meant to reassure banks that their traditional functions will not change and that they will have a strong role to play in the digital currency. The crux of the proposal is to replace only cash (in monetary economic parlance: M0) with the digital currency, not bank deposits (M1 or M2). In a traditional financial system, cash and reserves represent central bank money (direct claims on the central bank). Bank deposits, though they are denominated in the same unit (say renminbi) as central bank money, are actually liabilities of commercial banks. This is a public-private partnership, where the central bank permits commercial banks to create money in exchange for submitting to its regulation. Some speculation has focused on whether central bank–issued digital currencies would upend this longstanding tradition by allowing individuals to have an account directly at the central bank rather than rely on commercial banks. The PBOC says this will not be the case in China, and that it will aim to “avoid disintermediation.” In fact, Vice Governor Fan makes the insightful argument that bank deposits are already digital, making it redundant to make then digital once more. Cash is what is not yet digital.

While it has not been determined yet how individuals will hold and transact with the new digital currency, they will be able to purchase it at banks. The banks, in turn, will have to match any sales of the digital currency with the same amount of traditional fiat currency, which they will deposit at the central bank. Unlike with deposits that require only fractional reserves at the central bank, no new money is created, and the digital version of the renminbi is a direct claim on the central bank. A digital renminbi that goes into the economy is matched by a traditional renminbi that leaves the economy and sits at the central bank. The digital currency will also not pay any interest. Fan sums it up by saying, “the debt and credit relationship of money in circulation will not change.” The digital currency is thus not at all like bitcoin, which has in essence only computer code backing it. It is a liability of the central bank, like cash.

Privacy, But Not from the PBOC

One of the primary draws of a currency like bitcoin is the ability to transact without being personally identified. While anonymity is beneficial for allowing people like average Venezuelans to protect their money from government confiscation, it also attracts criminals and other bad actors. In his interview, Fan considers the trade-off and recognizes that individuals want and should have more privacy from banks and other counterparties that can see their data and transactions. Privacy is not possible when any transaction has to be “tightly coupled” with an account like a bank account. The solution proposed is dubbed “controllable privacy” (可控匿名 in Chinese), which, like cash, aims to allow one to transact without handing over personal details by being “loosely coupled” with an account. However, to control for risks of tax evasion and other illegal activities, the central bank will be able to view transactions.

Digital Currency Will Be Limited to Traditional Functions

The PBOC may also impose transaction limits to ensure that the digital currency is primarily used for small payments, just like cash. These limits would be consistent with existing policy that tries to make large cash payments cumbersome. China’s largest paper bill is the 100 yuan note, worth just under $16, making it much harder to make large payments in yuan than in other currencies with larger denominations—the $100 bill, the 1000 Swiss franc bill, or the €500 note (sometimes dubbed the “Bin Laden”). Since the nuts and bolts of transaction clearing and settlement, security, and the methods of holding the new currency in digital wallets are not yet public, it is not clear how this will work.

One section of the statement explores ways to automatically implement "smart" contracts with computer code. While the potential to add new social functions is viewed positively, including automating tax paying and blocking terrorism financing, smart contracts will not be a part of the digital currency, at least at this stage. The explanation given is that legal footing does not yet exist to issue a digital currency that goes beyond traditional functions like a store of value, medium of exchange, and unit of account. However, whether this could eventually change is left open. If the pilot is successful, the PBOC may well be able to lobby for changes to the legal framework under which it operates that would allow smart contracts to be built in. Others, like private companies, may also be able to build smart contract functionality on top of the digital currency, but this is not yet part of the plan.

Benefits: Cheaper, More Secure, Greater Flexibility

Overall, Fan expects that it will be cheaper as well as easier and more secure to transact with the digital currency than with cash. Counterfeiting, a rampant problem in China, would also become less of an issue. One of the key benefits from the PBOC’s perspective is the ability to maintain flexibility in monetary policy when interest rates are cut down to the zero lower bound. Fan proposes variable transaction fees, as well as daily and annual transaction limits to give the central bank more tools to control the velocity of money and its supply when interest rates cease to be a viable channel for intervention.

Assessment: Bold Yet Cautious Plan

The proposal is a bold, if cautious step towards issuing a central bank–backed digital currency. There are many technical details to iron out, and keeping a system with so much monetary value secure will be of great concern. I expect that other central banks will follow the Chinese example, starting only with a digital substitute for cash that allows for institutional learning and experimentation without requiring a fundamental rethink of money and monetary policy. That said, the limited scope will surely not last forever if the pilot proves successful. The trade-off between privacy and control will be one of the great political battlegrounds of the coming decades, and these currency experiments are sure to raise the urgency of these debates. Central banks like China’s that have built up trust and credibility over decades or centuries have little use for “mining” or other systems that allow one to put trust in computer code instead of in centralized institutions. Characteristics of the plan show that political authorities will try to capture some of the benefits of digital currencies like bitcoin to marginally improve their existing monetary systems and control, while eschewing the decentralized, mostly trustless ledgers that made bitcoin truly innovative.

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