What a Chinese Digital Currency Means for the Dollar’s Future

At the present time, transactions between foreign governments are cleared through and processed in U.S. dollars; therefore, as it stands, the international monetary system could not function without the dollar. This state of affairs may seem undoubtedly beneficial to the United States; however, there are potential negative ramifications to a dollar-dominant system. Despite the dollar’s outsized role in global value chains, the Federal Reserve’s monetary policy is tailored specifically for domestic economic conditions in the United States. As such, when the American economy is healthy but foreign economies are not, the Federal Reserve’s policy can exacerbate the imbalance. 

Though the dollar is the by far the premier global reserve currency, past historical periods highlight not only the existence of alternative currencies but also multipolarity. Prior to World War I, the Sterling’s role was complemented to some degree by relevant international use of the French Franc and the Deutsche Mark. In the interwar period, the dollar’s surging international interest after the creation of the Federal Reserve set the stage for competition between the Sterling and the Greenback. These periods show not only that there can be competition among reserve currencies, even if one holds pre-eminent status, but also that the network effects associated with a reserve currency may be weaker than expected. 

It is an interesting contradiction that such conclusions are drawn from the late 19th and early 20th century and not, as one might expect, from the recent past. Financial innovation has reduced hedging and switching costs associated with currencies, while the rise of electronic payments has catalyzed faster international transactions. Though such innovations should theoretically lay the foundation for a rival to the dollar, the dollar has generally remained the unipolar center of the international monetary system despite widespread emerging markets crises in the 1990s and the financial upheaval of the late 2000s.

While these innovations have failed to deliver an alternative to the dollar, new fintech developments herald the emergence of a rival to the dollar, even one controlled by one or more central banks. For merchants and vendors, invoicing in this new, more efficient currency is incentivized by more advanced settlement technologies, which can overcome the network effects of the dollar. In contrast to blockchain-based private digital currencies, a central bank digital currency (CBDC) would not need to be blockchain-based; it would already feature a trusted, third party entity to verify transactions— the central bank.

To be clear, the CBDC would not just be a digital token like Bitcoin given that much of the existing supply of currency, even in the United States, exists digitally already. On a micro level, the money deposited by an employer into an employee’s bank account no longer involves physical shipments of cash: it is a completely electronic process. On a macro level, the Federal Reserve does not physically ship cash around when managing the supply of money by buying or selling financial assets. The Federal Reserve too creates new money digitally. The selling point of a CBDC is not that it is digital but instead its effects on the structure of central bank liabilities.

Today, when banks transact with the Federal Reserve, they do so through FED deposit accounts, which are similar to those held by regular citizens at Bank of America, Wells Fargo, and Chase. After the financial crisis of the late 2000s, the Federal Reserve expanded the money supply by buying Treasury bonds from financial institutions via quantitative easing. In practical terms, when the Federal Reserve received a Treasury bond from a bank, it would create new money electronically in the form of reserves. The goal of this was not to increase activity in financial markets but in the real economy as a whole.

On an individual level, a CBDC could increase the transmission of monetary policy by having a direct impact on the average person, who has an account at the central bank. Instead of using banks as an intermediary for monetary policy, the introduction of a CBDC could allow for central banks to directly influence consumer behavior. In one particular case, a CBDC could boost the effectiveness of negative interest rates if its use materially reduced cash circulation or overcame banks’ unwillingness to pass deposit rates to their customers to keep a competitive advantage. Yet, there are costs to this that could easily materialize that are best encapsulated in the effect on the banking system.

Should deposits flock from commercial banks to the central bank, especially uninsured commercial deposits, the effect on credit supply could have an adverse impact on the real economy. In other words, commercial banks, which take depositors’ money and lend it to businesses, would have access to a smaller funding base, ceteris paribus. It is entirely possible that the new entrant of the CBDC could be met with higher private deposit rates to attract new and retain existing customers that could potentially expand banks’ deposit bases altogether if higher rates incentivize unbanked to open deposit accounts. Still, the competition between the CBDC and commercial banks highlights that the core debate lies not in monetary policy but in prudential and regulatory affairs.

So long as CBDC proposals that have been unveiled fail to answer these questions and speak to the traditional problems associated with existing alternative reserve currencies, its chance of dethroning the dollar on technological merit remains slim. China, in particular, has been cited for its advanced payments systems, especially Alipay and WeChat Pay, but these could have mixed effects for a CBDC. In particular, Alipay’s Yu’e Bao and WeChat’s Licaitong are likely to provide fiercer competition for CBDC adoption; however, it could also create a scenario in which higher competition for deposits facilitates greater financial inclusion thus achieving a CBDC’s objective. In spite of the potential benefits, the prudential risks associated with this proposal remain unanswered thereby rendering the effect of the technology on reserve currency network effects unclear. 

In the long run, despite more advanced payments technology, it will be incumbent that China pursue further liberalization to render its currency more attractive. Unlike Europe, which adopted widespread Deutsche Mark- and later euro-denominated invoicing regionally, East Asia has consistently used the dollar. In spite of such liberalization efforts, the Yen’s international push failed to overcome the dollar’s attractiveness, even with the migration of Japanese value chains into Southeast Asia. As a long-term conjecture, if Chinese authorities committed themselves to similar liberalization efforts and further development of local capital markets, more convenient payments technology, like Alipay or WeChat Pay, could catalyze greater international use of the RMB.

Still, placing payments technology ahead of the nature of the payment currency itself is analogous to the placing the cart before the horse. China’s CBDC could carry significant economic effects domestically in the short-to-medium term, but, absent further reforms, the RMB and, by extension, an RMB-based CBDC are likely to have little international attraction. Especially with the relaxation of network effects in reserve currencies, the dollar’s current international status speaks less to the dollar’s exceptionalism and more to the lack of credible alternatives. In the end, only time and serious reforms will be enough to change that outcome.

Statements and views expressed in this commentary are solely those of the author and do not imply endorsement by Harvard University, Harvard Kennedy School, or the Belfer Center for Science and International Affairs.

 Michael B. Greenwald is a fellow at Harvard Kennedy School’s Belfer Center for Science and International Affairs. He is also a senior adviser to Atlantic Council President and Chief Executive Officer Frederick Kempe and an adjunct professor at Boston University. From 2015-2017, Greenwald served as the US Treasury attaché to Qatar and Kuwait.