China Aiming to Issue a Central Bank Digital Currency
—Expected Macro-Level Effects

The global wave of the digital revolution has reached into the field of currencies. In China, cashless payment has become popular as a result of the diffusion of electronic money services, such as Alipay, and interest in central bank digital currencies (hereinafter referred to as "CBDCs") is growing (Note 1). Indeed, the People's Bank of China (PBoC) has been ahead of other countries' central banks in research on CBDCs, and the issuance of a CBDC in China is about to move from the planning stage to the implementation stage. In this paper, I explain China's CBDC scheme as revealed by experts involved in this process and consider macro-level effects that the issuance of a CBDC may have on monetary policy, the financial system, mainly commercial banks (hereinafter referred to as "banks"), and the internationalization of the Chinese yuan.

In recent years, discussions on CBDCs have become active, mainly at international organizations, such as the International Monetary Fund and the Bank for International Settlements (BIS), and at central banks. Among the factors behind this trend are growing expectations for CBDCs with respect to the following matters: (i) efficiency improvement and cost reduction of the payment settlement process due to new information technology, (ii) a decrease in cash in circulation and promotion of financial inclusion in some countries, including Nordic countries, (iii) arrival of blockchain and other decentralized ledger technologies and crypto assets (virtual currencies), (iv) prevention of crime and tax evasion and AML/CFT (anti-money laundering / countering the financing of terrorism), (v) improvement of the effectiveness of monetary policy, and (vi) contribution to financial stability (YANAGAWA Noriyuki and YAMAOKA Hiromi, "Digital Innovation, Data Revolution and Central Bank Digital Currency," Bank of Japan Working Paper Series, February 2019).

Let us look at the position of a CBDC as defined by BIS in relation to other currencies based on the "money flower" classification, which relies on the following four criteria: (i) issuer: whether the issuer is a central bank (legal currency) or other institution (private currency); (ii) form: whether the currency is issued in a digital or physical form; (iii) accessibility: whether the currency is a retail type that is widely accessible or a wholesale type with limited accessibility; and (iv) technology: whether the currency is a token type for which transfer is implemented directly without an intermediary or an account-based type for which transfer is implemented via an intermediary (Figure 1).

Note: Currencies in the grey area are CBDCs.

Source: Compiled by the author based on Morten Bech and Rodney Garratt, "Central Bank Cryptocurrencies," BIS Quarterly Review, September 2017

A CBDC is a legal currency that is issued by a central bank and concurrently meets criteria (i) and (ii) in the money flower diagram. If criteria (iii) and (iv) are also taken into consideration, CBDCs are classified into four types—(A) retail/account based type, (B) retail/token type, (C) wholesale/account-based type, and (D) wholesale/token type (Note 2).

Di Gang, deputy head of the PBoC Digital Currency Research Institute, observed that the scope of the development of a CBDC by the PBoC excludes the two wholesale types, namely Types (C) and (D), and is limited to the two retail types, namely Types (A) and (B) (Di Gang, "Digital Currency Analysis," China Finance, 2018-17).

The two retail types, Types (A) and (B), have the following respective characteristics (Institute for Monetary and Economic Studies of the Bank of Japan, "Report of the Study Group on Legal Issues Regarding Central Bank Digital Currency," September 2019).

In the case of Type (A), which is an account-based type, account holders of the issuing central bank are not limited to financial institutions as is the case under the current currency system, but general users, including individuals and non-financial companies, are allowed to open accounts. In this case, the CBDC represents a claim on deposits held by a general user against the central bank. The transfer of CBDC as a claim on deposits is implemented through the recording of an increase or decrease in the account balance.

Meanwhile, in the case of Type (B), which is a token type, the CBDC is regarded as a digitalized version of paper money. In other words, monetary value is considered to be stored in an electronic form instead of in a paper form. CBDC data recorded in a dedicated electronic wallet, including a smartphone app or an IC card, for example, represents monetary value. Settlement does not go through an account (of either the central bank or commercial banks) but is conducted directly in the form of data transfer between electronic wallets. Generally speaking, a token-type CBDC that uses electronic wallets for the settlement purpose provides a higher level of anonymity than an account-based CBDC.

China's research concerning CBDCs started in 2014, when Zhou Xiaochuan, who was PBoC's governor at the time, mentioned the need to study the possibility of the central bank issuing a digital currency. Thereafter, a study team was created within the PBoC to prepare for the issuance of a CBDC, and the Digital Currency Research Institute was established in 2017.

Now, China's CBDC scheme is about to move from the planning stage to the implementation stage. On August 10, 2019, Mu Changchun, the head of the Digital Currency Research Institute, speaking at the Third China Finance 40 Forum, stated that China's CBDC project is moving closer to the introduction stage and explained the details of the planned CBDC scheme. In addition, speaking at the Bund Financial Summit that was held on October 28, Huang Qifan, a former mayor of Chongqing and vice chairman of the China Center for International Economic Exchange, a government-affiliated think tank, mentioned the possibility that the PBoC might become the world's first central bank to issue a digital currency, creating a buzz both within and outside China.

Regarding the introduction of the CBDC, speaking at a press conference related to the 70th anniversary of the founding of the People Republic of China on September 24, 2019, PBoC Governor Yi Gang said that a specific issuance schedule had not yet been fixed and that processes such as pilot testing and risk assessment remained to be implemented. According to an article carried by Caijing, a Chinese business magazine, the PBoC would soon start CBDC tests in Shenzhen and Suzhou and that tests were also planned in other cities and regions (Zhang Wei, "Eve of the Birth of Digital Currency in China: Pilot Testing by the Central Bank and Competition between the Four Major Banks—Can China Lead the World?" Caijing, December 9, 2019).

Although many countries are conducting research on CBDCs, China is a step ahead of others in this international competition. China's CBDC issuance scheme, underlying technology, the results of research related to social acceptance and operational cost, and introduction efforts are expected to be useful as sources of reference information for other countries as well.

According to what has been said, verbally and in writing, by experts participating in this project, including the abovementioned speech by Mr. Mu, the head of the Digital Currency Research Institute, China's CBDC scheme corresponds to Type B, namely a retail/token type, and has the following characteristics.

(i) Substitution for M0
The CBDC substitutes for M0 (cash) but not for M1 (cash + demand deposits) or M2 (M1+quasi currency, such as time deposits). This means that the CBDC is expected to function as a means of settlement, rather than as a means of storing value. Under the present Chinese financial system, M1 and M2 have already been digitalized in the form of account management, so it is unnecessary to use other digitalization technology. One reason cited for promoting the CBDC is that paper currency and coins are not only costly to print or mint, issue, and store compared with digital currencies, but their use also requires continuous investment in research and development on technology to prevent counterfeiting. In addition, cash is exposed to the risk of being used for money laundering or financing of terrorism because it provides transaction anonymity. Issuing the CBDC will help to ease those problems involved in the use of cash.

(ii) Two-tiered operation system
As in the case of paper money, the operation of the CBDC scheme, including the issuance and distribution of the digital currency, will be based on a two-tiered system (Figure 2). The first tier is comprised of transactions between the PBoC and intermediaries, including banks, and the second tier is comprised of transactions between intermediaries and retail market participants, including individuals and companies. Regarding the first tier, the PBoC will issue the CBDC to intermediaries. Regarding the second tier, intermediaries that receive the CBDC will distribute it so that it can circulate through the market. Intermediaries are considered to be likely to include non-financial companies such as Alibaba, Tencent, and UnionPay, in addition to the four major banks (China Construction Bank, the Industrial and Commercial Bank of China, the Bank of China, and the Agricultural Bank of China) (Michael del Castillo, "Alibaba, Tencent, Five Others to Receive First Chinese Government Cryptocurrency," Forbes, August 27, 2019). The transfer of the CBDC will occur between electronic wallets, rather than between bank accounts.

Note: CBDC may also be used between individuals and between companies.

Source: Compiled by the author based on a speech made by Mu Changchun, at the Third China Finance 40 Forum on August 10, 2019.

Among the reasons cited for adopting the two-tiered structure are: (i) that because of China's huge economic size, it is difficult for the central bank to issue the CBDC directly to the people; and (ii) that if the central bank issues the CBDC directly to the people, it could become a potential competitor with banks. As Type (A), which is a retail/account-based type, has effectively been ruled out as an option, Type (B), which is a retail/token type, is the only remaining option among the four types earlier mentioned.

(iii) Not limited to particular technology
As for CBDC technology, the PBoC does not necessarily have to adopt blockchain or other decentralized ledger technology but may use alternative technology. As the CBDC is expected to be used mainly for small-lot transactions, such as online shopping, a trading system capable of processing a massive volume of transactions at high speed is required. Mr. Mu, the head of the Digital Currency Research Institute, has pointed out that the CBDC scheme requires a trading system capable of processing at least 300,000 transactions per second and that this is a speed difficult to be achieved through the block chain technology currently available.

(iv) Not bearing interest
In order to minimize competition between the CBDC and bank deposits, the central bank will not pay interest on the CBDC. This is consistent with the CBDC's intended function, which focuses mainly on settlement.

(v) Treatment of personal information based on "controllable anonymity"
The issuance and circulation of the CBDC will enable the recording of entire transaction histories, and this is useful as a deterrence against anti-social activities and tax evasion. On the other hand, as the central bank is in a position to keep track of information on all transactions, there are some challenges to overcome, such as how the central bank should treat the information and whether individuals' privacy, including personal financial information, can be protected. On this point, Mr. Mu remarked in his speech in Singapore that as the Chinese authorities are aware of some people's wish to maintain anonymity by using paper currency and coins, transaction anonymity for those people will be secured. He also observed that the right balance will be kept between "controllable anonymity" and the need to address matters such as money laundering, financing of terrorism, tax issues, online gambling, and electronic criminal activities. ("China's digital currency not seeking 'full control' of individuals' details: central bank official," Reuters, November 12, 2019).

(vi) Enabling off-line transactions
The CBDC scheme will enable settlement even if both the payment and receiving sides are in an off-line environment. If each side possesses a smartphone or other terminal installed with a CBDC wallet, a fund transfer can be implemented through physical touch between the two terminals—so long as the batteries are charged—without the presence of fixed or wireless Internet access.

In light of the abovementioned characteristics of the planned CBDC scheme, we can see some common points and differences between China's planned CBDC and other digital currencies (Table 3).

[Click to enlarge]

Note: In China's case, third-party settlement agencies, such as Alipay, are required to deposit at the central bank the same amount of reserves as the amount of deposits held by customers in their accounts. Therefore, there is the view that deposits held in customer accounts are equivalent in effect to central-bank liabilities and involve no credit risk.

Source: Compiled by the author based on various reference materials, including Guosheng Securities Research Institute, "Digital Currency/Electronic Payment (DCEP) in China: Elementary Analysis Concerning the Goal, Position, Mechanism and Impact."

The CBDC scheme will give the central bank a new monetary policy tool. If the CBDC is issued, it will be added to the liability side of the central bank's balance sheet, which also includes cash in circulation and reserves held by financial institutions. The asset side of the balance sheet includes such items as re-lending to domestic financial institutions and foreign exchange reserves. The central bank will be able to make liquidity adjustments by releasing (collecting) the CBDC through the purchase (sale) of foreign currencies or through the expansion (shrinkage) of re-lending.

If the CBDC functions not merely as a means of settlement (substitution for M0) but also as an interest-bearing asset, the interest rate on CBDC, which corresponds to its "price," as well as its quantity, may serve as a monetary policy tool. Introducing an interest-bearing CBDC will facilitate the implementation of a negative interest policy. Generally speaking, paper currency (cash) issued by the central bank does not bear interest. If the authority tries to lower interest rates on financial assets below zero as an economic stimulus measure, people holding the financial assets would prefer to convert them into cash. This means, in effect, that the lower limit on financial asset interest rates is zero, and the zero interest threshold serves as an obstacle (liquidity trap), making the monetary policy ineffective. However, if an interest-bearing CBDC is issued and if cash is abolished (or if high-value paper currency, at the least, is abolished) at the same time, interest rates on deposits and other financial assets may be lowered below zero in tandem with the CBDC interest rate, making the monetary policy all the more effective.

The arrival of the CBDC could accelerate the decline of banks' influence. This problem will become even more serious if an interest-bearing CBDC is introduced.

Banks are at the center of the modern financial system. They absorb deposits, hold reserves at the central bank, and create credit by extending loans. Banks also manage deposit accounts held by companies and individuals and process settlement. As banks have an outstanding advantage in settlement and deposit-taking, they also have an advantage in related businesses, such as asset management and insurance.

However, following the arrival of electronic money, platform companies that process third-party settlements have become the vanguards of FinTech and are encroaching on the banks' central role in the financial system, as the flow of information obtained through the settlement process shifts from banks toward those companies. If major platform companies join the ranks of CBDC intermediaries in China, this trend will gain further momentum. On the other hand, as the CBDC does not have a third-party settlement function, it will not compete with Alipay and other electronic money services that provide third-party settlement services. If a CBDC is issued, it will partially substitute for bank deposits because payment and receipt of funds between users and third-party settlement agencies do not have to go through a bank account but can be processed directly via CBDC.

If a CBDC is issued, it is likely to substitute not only for M0 (cash) but also for demand deposits, which are part of M1. If an interest-bearing CBDC is introduced, it is also expected to substitute for savings bank deposits that form part of M2. Because the central bank has a high level of creditworthiness, if interest and other conditions are equal, savings bank deposits are likely to be replaced by the CBDC, a situation that could significantly reduce banks' deposits and related businesses. In particular, outflows of deposits from banks will significantly reduce their lending capacity, forcing some of them out of business. As a result, the entire financial system could become unstable. In light of the expected magnitude of the impact, an interest-bearing CBDC is unlikely to be introduced until ways are found to solve problems regarding how to make up for the expected shrinkage of banks' lending and how to maintain financial system stability.

The issuance of a CBDC in China is expected to contribute to the internationalization of the yuan by enhancing the convenience of using the Chinese currency. In recent years, the use of the yuan for the settlement of cross-border transactions, including trade, fund procurement and investment transactions, between China and other countries has increased, thanks to the government's efforts to promote it as well as the rise and globalization of the Chinese economy. In China, online settlement has reached into every corner of the people's everyday lives compared with the situation in the United States. The technologies and experiences accumulated as a result are sure to be useful for promoting the use of the Chinese CBDC in and outside China. International use of a currency depends largely on economies of scale and inertia. China's lead over the United States in issuing a CBDC and promoting its international use is likely to create a favorable condition for the internationalization of the yuan.

However, for the internationalization of the yuan to make progress, the following conditions must also be satisfied: (i) that China, as the issuer, has a well-developed financial market, allows free capital transactions, and secures equal market access for residents and non-residents; (ii) that confidence in the yuan is established; and (iii) that China's share in the global economy (in terms of gross national product [GNP] or trade value) is large. Regarding these conditions, China's strict capital controls pose the greatest obstacle to the internationalization of the yuan. As the forthcoming CBDC is also expected to be subjected to strict capital controls, the effects of its introduction on promoting the internationalization of the yuan is expected to be limited. Indeed, former PBoC Governor Zhou Xiaochuan, stated that the Chinese CBDC is intended for use in domestic transactions, rather than in cross-border transactions (Zhou Xiaochuan, "Zhou Xiaochuan Talks About Digital Currency and Electronic Payment," Caixin Online, November 21, 2019).

China is likely to become the first country in the world to introduce a CBDC in earnest. In preparation for the introduction of the CBDC, China is engaging in meticulous planning and is expected to continue to be cautious after moving to the implementation stage. Ultimately, the CBDC will completely replace cash in China, realizing a fully cashless society, but there is still a long way to go before reaching that point. During that transition period, the greatest challenge will be how to respond to the decline of banks' influence and financial system disruptions that could ensue.

The original text in Japanese was posted on December 27, 2019.