No threat yet to US dollar’s status as world’s reserve currency

Ever since China started pilot project on its Central Bank Digital Currency (CBDC), there has been a spate of articles predicting a possibility of China’s digital currency replacing the US dollar as the reserve currency of the world. It is time to apply some reality checks to this speculation.

Before we start examining the validity of the claims, it will be useful to understand a little about the CBDC. Precious little is known about the model adopted by China, therefore this article bases its understanding on the material provided by the European Central Bank and the Bank of England.

First , a CBDC is as different from a cryptocurrency as chalk is from cheese. The only common point being that CBDCs are likely to use distributed ledger technology.

Second , CBDC is just another form of central bank’s fiat currency and is within the overall monetary policy of the central bank and is readily exchangeable into a bank note or any other form of central bank liability.

Third , the central bank does not directly participate in the transactions and uses intermediaries who may be banks or non-banks.

Fourth , the anonymity provided is nowhere near that provided by cash. Large value transactions are necessarily visible to some anti money laundering authority. Better anonymity is provided to small value transactions; better in the sense that the transaction is visible to lesser number of entities.

Finally , the main reason for launching CBDC appears to be to provide low cost transfer facility even to people who do not have a bank account. Going by the statements made by Chinese central bank officials, this is the main reason for launching a digital currency.

Extending this logic, the Chinese CBDC may be used by increasing number of people to make international transfers at low cost. Further, it may provide an alternative channel to dollar-based payments to those jurisdictions that are on the sanction list of the US. Therefore, in the near future it may partly replace the dollar as medium of exchange in international financial transactions. Yet this covers only one function of money — that is, medium of exchange. However for gaining the status of reserve currency, it has to perform the store of value function also.

Renminbi bonds

That will happen when renminbi bonds become popular investment instruments. Apart from the issue of trust, there is a problem of supply of enough renminbi bonds. With an export surplus economy, it is difficult to envisage how China will be able to manage supply of enough bonds to maintain an uninterrupted supply line and a stable yield curve.

A possible solution could be to issue these bonds with backing of dollar reserves that China has. This may help China to finance its domestic projects without disturbing the local exchange rate. Even this solution has a twofold problem. One, it may involve cost for China as the investors will demand a yield that is slightly higher than that of US Treasury Bonds, on a fully hedged basis.

And second, and more importantly, though it may give China a foothold in the international bond markets, yet the ultimate reserve currency will still remain the dollar.

What is the solution for China? Traditional wisdom demands when one wants to be seen as a king, one has to start living as a king. Till China learns to splurge and run a deficit, it will be difficult for the renminbi to become a reserve currency. But if it did that, will it not be doing exactly what the US wanted it to do in the first place?

In the end, is there a lesson for India in this episode? India already runs a very reliable and almost cost free payment system for its people. If there is a first mover advantage, it has already gone to China or may be to the UK or Europe. Perhaps it will be better for India to wait till the CBDC models and technology mature.

The write is Senior Consultant, Shardul Amarchand Mangaldas & Co.

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