Digital debut

.The country that invented fiat money in the 12th century (not to mention the paper it was printed on), wants to become the first to launch its digital equivalent in the 21st.

There has been a gap of almost a thousand years, but once again China stands poised on the cusp of a revolution that could reshape our understanding of what money means and, by definition, how we conduct our day-to-day lives. The country that invented the concept of fiat money in the 12th century says it will become the first to launch its digital equivalent in the 21st.

China’s pacesetting role in the history of money, particularly during the Tang and Song Dynasties, is often overlooked in the West. In more recent times, Europe and then the US has moulded and, therefore, controlled what became a globally integrated financial system.

But the Chinese have not forgotten and the central government is determined to overturn the dollar’s current hegemony by leading the huge financial changes being driven by the digital era. The past week has been punctuated by a series of announcements and one piece of legislation that could bring that closer to reality - ahead of the rest of the world.

All of this was heralded by comments from President, Xi Jinping. Last Friday, he said that China should “seize the opportunities” afforded by blockchain.

His pronouncement prompted a spike in domestic Internet searches, as Chinese citizens attempted to understand what the word actually meant. It was also significant that the government was effectively endorsing a technology it had previously restricted for fear of losing control over its financial system.

The turnaround also prompted similar spikes in the value of companies associated with blockchain. Nasdaq-listed Xunlei’s share price doubled in the space of a day, for example.

On the day after Xi’s remarks, China issued a new cryptography law to regulate data encryption. Then at the beginning of this week, Huang Qifan, vice chairman at the think tank, China Centre for International Economic Exchanges (CCIEE), gave a glimpse of the plan to issue the world’s first sovereign digital currency (something that has been dubbed DCEP - digital currency electronic payment).

In a speech to the inaugural Bund Summit in Shanghai, the influential former major of Chongqing explained that, “for a sovereign state, the only cryptocurrency that works is one backed by government.” What he means is that only governments engender the levels of trust that can convince end-users to accept a means of financial exchange that has no intrinsic value of its own.

In this respect, the new digital currency shares much the same principle as its Song Dynasty predecessor. In the late 12th century, the Song government ruled that its bank notes could not be converted into metal, making China the first sovereign state to issue paper money unbacked by a physical commodity held as a reserve by the issuing institution. Later, European explorers like Marco Polo were astounded, particularly given they did not even have paper, let alone paper money.

However, the system eventually collapsed. Successive dynasties failed to comprehend how overprinting of money fuelled inflation and corroded the value of the intangible commodity that backed it – trust in the respective government’s ability to make it good (fiat).

Huang’s speech represents the most important yet by a high-ranking political official. It laid out the how and why China wants to lead the digital financial era.

The why has been obvious for some time: China wants to dismantle the “exorbitant privilege” the US enjoys thanks to the dollar’s enduring star power. The latter has not diminished even as China carves out an ever-greater role in global trade flows.

The most recent Bank of International Settlements (BIS) data shows that the US dollar accounted for 88% of the $6.6 trillion traded on the foreign exchange markets each day in April. China’s yuan came in eighth on just 4%.

Even Belt and Road projects are mainly dollar-denominated. Central University’s Zhang Liqing has previously told Yicai.com that only 14% of payments are transacted in the renminbi.

Huang added that global payment systems such as SWIFT and CHIPS have “become financial instruments for the US to exercise global hegemony and carry out long-arm jurisdictions,” such as punishing financial institutions that transfer money to countries, companies, or individuals Washington does not like.

China wants to exert more of that control instead. It also wants to solve the dilemma of currency overshoot: whereby the dollar’s reserve currency status has created a ballooning of US debt and the Fed’s balance sheet as the latter tries to absorb global financial shocks.

Huang believes that digital currencies should be linked to sovereign credit, national GDP, fiscal revenues and gold reserves to keep them stable. The how China plans to achieve this, has not yet been fully publicly articulated, but the outlines are becoming clearer.

Huang said that China plans to launch an encrypted, electronic form of money based on blockchain (a system of digital ledgers, or ‘blocks’ of information, maintained across a network or ‘chain’ of computers) that accredited users will have access to.

He added that e-money would be launched in two stages. The central bank would issue DCEP to authorised institutions, which would then make it available to the public.

Huang also made it clear that the government does not envisage a “digitization of China’s existing currency, but an alternative to MO” (defined as coins and notes in circulation outside the central bank). Forbes has reported that the participating financial institutions are likely to comprise China’s big four state-owned banks, plus Alibaba and Tencent.

This will have profound consequences. A digital currency using blockchain technology will give the central bank a much clearer idea of where the currency ends up, something that currently gives the two tech giants their edge in the payments business.

Huang said as much when he noted that DCEP would help the government to formulate monetary policy and counter money laundering. He has not mentioned a launch date for the currency, but some commentators believe that regulators have accelerated their plans after becoming concerned about the implications of Facebook’s Libra project, which was officially launched in June.

The latter envisages the issuance of digital stablecoins, which are tied to a currency basket dominated by the US dollar. This peg should make Libra theoretically more stable than cryptocurrencies like Bitcoin, which are not backed by anything at all.

Facebook views Libra as a means for its 2.41 billion monthly active users to conduct financial transactions, particularly the millions of unbanked customers in the world’s frontier markets. But China sees it as a potential threat, not least because the renminbi has not been included in the currency basket.

So too, do many of the world’s central bankers and finance ministers. In a recent Financial Times editorial, French finance minister, Bruno Le Maire, said, “ I cannot countenance one of a sovereign state’s most powerful tools, monetary policy, falling under the remit of entities not subject to democratic control.”

Libra would break the contract between sovereigns and the merchant class that has existed since the Bank of England (BOE) was established in 1694. In return for being allowed to create and manage money, financial institutions agreed to governmental oversight of their activities and also accepted central banks as lenders of last resort by depositing some of their reserves with them.

The BOE’s current head, Mark Carney, has suggested that central banks should work together to create a public version of Libra backed by multiple currencies in a network run by central banks. But many US politicians view control of their currency as a security issue. In testimony to Congress last week, Facebook’s boss, Mark Zuckerberg, played to a similar theme, warning that a Chinese alternative would be the main winner if Washington blocked Libra and predicted that this would also weaken America’s financial leadership of the world.

China’s media broadly welcomed talk of the new currency. Global Times said that China is “striving for a place in the financial world of the future.” However, the People’s Daily also cautioned that while blockchain is “moving in the right direction” it is “still in the early stages of development,” so it’s important to “avoid a rush.”

Mu Changchun, one of the principals leading China’s digital currency initiative, has pointed out that even the most sophisticated blockchain could not yet handle the 92,771 transactions per second recorded during 2018’s Single’s Day in China.

The last thing that China wants is to disrupt the renminbi at a time when the currency is already under a pressure. So as with most new policy ideas in China, expect, a pilot scheme in which the new digital currency will be trialled in a couple of cities first.