China’s digital currency project: What is DC/EP all about?
This article is joint work with Jonas Gross and was originally published on Medium.
Central bank digital currencies (CBDC) are becoming reality. On 16 April 2020, the Chinese central bank has started the test phase of its CBDC, called Digital Currency / Electronic Payment (DC/EP). It is currently tested in four Chinese cities: Shenzhen, Suzhou, Chengdu, and Xiong’an. China might be the first industrial economy worldwide to introduce a CBDC. This article outlines the current status of the DC/EP project and its economic and social implications.
Mobile payments in China widespread
With 790 million users, more than 60.5 billion transactions, and a transaction volume of USD 41.5 trillion, China is a global pioneer in mobile payments. Studies in the cities of Shanghai, Beijing, and Hangzhou show that the market share of mobile payments is up to 60%, compared to 20% cash. According to the Deutsche Bundesbank, in Germany, cash accounts for almost 50% of the payment volume, while mobile payments are negligible. Given the widespread use of digital payments, it is not surprising that the Chinese central bank, the People’s Bank of China (PBoC), has been working on its own digital currency since 2014. As early as 2016, a research institute for the Development of Digital Currency/Electronic Payment (DC/EP) was founded. In April 2020, the DC/EP project reached an important milestone: the test phase.
The test phase has begun
The Chinese CBDC is currently being tested in four Chinese cities: Shenzhen, Suzhou, Chengdu, and Xiong’an. Up to 50% of the mobility subsidies of government employees are paid out in digital form via mobile DC/EP wallets. Numerous banks, telecommunication, and e-commerce companies such as Tencent and Alibaba participate in the test phase. According to Shirley Yu, Asia fellow at the Harvard Kennedy School, large US franchise companies such as McDonald’s, Starbucks, and Subway have become the first vendors accepting the Chinese CBDC. A second major test run is planned during the 2022 Winter Olympics in Beijing.
How exactly the test runs will be carried out and how the DC/EP will ultimately be designed is still largely unclear. Information about the Chinese CBDC is quite rare, and communication by the PBoC is relatively opaque compared to western CBDC projects. The published information mostly stems from media reports or cooperation partners and only partly from the PBoC itself.
Design of the DC/EP
The Chinese CBDC is more than just another form of mobile payment. It aims to replace a part of the M0 money supply in the Chinese monetary system. Hence, DC/EP is a digital form of the physical Renmimbi (RMB). It is designed as digital cash and does therefore not carry any interest rate.
DC/EP uses a two-tiered system. The first layer is between the central bank and the banking sector, including also Alipay and WeChat Pay. Through this wholesale layer, the PBoC supplies CBDC to banks. These banks can then channel the CBDC through the second layer to retail clients via digital wallets. Clients do not need to hold a bank account to use the DC/EP.
The Chinese CBDC is not decentralized. The decision power is fully allocated to the central bank, even if distributed ledger technology (DLT) might be one technology used for the DC/EP. The exact role of DLT remains unclear at this point.
How do transactions take place?
Payments with DC/EP will be possible by scanning a QR code or touching another smartphone. The latter possibility would be particularly relevant in the case of a limited Internet connection. So far, however, the insights into the transaction process are still too rudimentary to make an in-depth analysis.
Goals of the DC/EP project
What are the intentions of the PBoC with the CBDC project? The PBoC wants to promote digitization in China and is reacting to a decreasing demand for cash. Significant efficiency gains can be realized through digital payment processing. Cash is relatively expensive due to the costs of storage, sorting, cleaning, and its distribution. A public digital payment system could significantly reduce these costs. COVID-19 might also contribute to an increasing demand for digital payments in the future, as citizens fear virus infections through banknotes.
Currently, the majority of transactions in China are processed via private payment systems such as Alipay and WeChat Pay. The PBoC intends to create a public transaction platform to reduce the systemic relevance of these companies in the market for payments and thus strengthen both PBoC’s supremacy and financial stability.
Privacy and capital controls
Experts fear that the DC/EP project will negatively affect the freedom of Chinese citizens. Presumably, data on the transaction amount, location, and payment sender and recipient will be visible to the central bank. In addition, personal data, such as the identity of the payee, will be stored digitally. In this way, the PBoC would gain insight into the payment behavior of Chinese citizens.
Potentially, the DC/EP system could also be interlinked with the social credit system creating the possibility to exclude citizens from making financial transactions if they do not play by the rules. According to the Guardian, 23 million people had been prohibited from purchasing flight and train tickets by the end of 2018.
Finally, full control over the payment system also enables the central bank to implement capital controls more effectively. While the PBoC can control the movement of physical banknotes only to a limited extent, a CBDC would enable full control over cross-border capital flows. It should be noted, however, that partially anonymous payments in DC/EP could be allowed. Alipay has filed a patent application for anonymous payments with DC/EP.
How large will the DC/EP become?
Citic Securities estimates that the DC/EP project could reach a total size of 1 trillion Yuan (140 billion US dollars) in the next few years. This would correspond to the digitization of about one-eighth of the cash in circulation in China. However, the volume could be considerably higher if, for example, foreign investors were granted access to DC/EP.
This could lead to an internationalization of the Yuan. Might the Chinese CBDC challenge the hegemony of the US Dollar as the world’s reserve currency? According to data from the International Monetary Fund, we are still far away from that. At the end of 2019, the US dollar has accounted for more than 60% of global foreign exchange reserves with the RMB accounting for less than 2%. The digital Yuan will not simply become the world’s leading currency only because it is digital. Eventually, it will be the strength of the Chinese economy and China’s willingness to open its economy to international investors that will drive the global use of the Yuan.
Ex ante, it is not clear to what extent the Chinese government is willing to take the necessary steps to enable the internationalization of its currency. There is a tradeoff between the global use of the Yuan and the strict Chinese capital controls. If the PBoC intends to use the DC/EP to strengthen the Yuan’s international position, capital controls would have to be restricted.
In the long run, there is pressure to move towards state-backed digital currencies because these currencies create an easily accessible store of value and means of payment for investors around the world. The digital Yuan brings the Chinese currency to the international stage and could eventually challenge the US Dollar’s dominance in the future.
DC/EP project as a global pioneer
The current progress of the DC/EP project shows that China is a CBDC pioneer, even though a market launch of the CBDC will take at least until 2022. There are smaller countries or island groups, such as the Marshall Islands or the Bahamas, which are already working on a CBDC and are at a similar stage of development. However, these CBDC initiatives primarily address the limited number of inhabitants of these islands, while DC/EP would be available to billions of Chinese citizens and maybe even beyond.
The European Central Bank (ECB) is also working intensively on a CBDC for the euro area. So far, however, this is more conceptual work. According to ECB Executive Board member Yves Mersch, the introduction of a CBDC in the Eurozone is unlikely to happen in the near future due to the still strong role of cash.
In the US, efforts to establish a CBDC are currently purely driven by the private sector. The Digital Dollar Project, which is a joint venture by Accenture and the Digital Dollar Foundation, has taken a leading role. On 29 May, they published a white paper describing their model of a US Dollar CBDC. The Fed remains silent about whether it is working on a CBDC itself.