Tsinghua Financial Review: Monetary System, Modern Central Bank and Digital Currency

This article was published in the March 2021 issue of Tsinghua Financial Review

By Qiao Yi, Vice President and Secretary General of Shanghai Development Research Foundation

Editor's Note

To truly understand these changes, we must examine digital currency in a broader perspective and analyze the future trend of digital currency and its impact on the economy, finance, and monetary system by understanding the evolution of the monetary system and the formation of the modern central bank system. In the future, the value advantages of legal digital currency can also be further explored. In the March 2021 issue of Tsinghua Financial Review, experts and scholars were invited to discuss this in order to open up the imagination space of central bank digital currency.

Introduction

Digital currencies, including central bank digital currencies, are the focus of current regulatory, economic, and financial circles. People are concerned about the characteristics and development trends of digital currencies and their possible impact on the economy and finance. To truly understand these, we must examine digital currencies in a broader perspective and analyze the future trend of digital currencies and their impact on the economy, finance, and monetary systems by understanding the evolution of the monetary system and the formation of the modern central bank system.

The evolution of monetary systems

Generally, people come into contact with money mainly for its exchange, pricing and value storage functions, so naturally they pay more attention to the material and physical form of money. However, the institutional factors contained in the same material of money may be very different. As for paper money, my country was the first in the world to use "Jiaozi" produced in Sichuan during the Song Dynasty, but compared with the paper money we use today, it is incomparable in terms of the issuer, issuance method, scope of use and impact on finance.

When studying the history of currency, some scholars divide currency into physical currency and metal currency. The former corresponds to the so-called natural economy, and the latter corresponds to the monetary economy. This division makes sense, but there are also some problems. For example, precious metals such as gold and silver have their own use value and can also be considered as physical objects. Therefore, we should understand the institutional factors behind the evolution of currency from a deeper perspective.

From the perspective of the development of currency, what goes beyond its material, shape and composition is its connotation, that is, the issuing (production) subject, the issuance method and its support, which can be referred to as the monetary system. The monetary system can be divided into three categories: the first category is that the currency itself contains use value. This includes shells, cattle, sheep, silk, etc., which are well known to people in the history of currency development, all the way to precious metals. This can of course also be called a non-currency system, because the currency itself has use value, and the producer can be an individual or a group. The second category refers to the various forms of currency under the monetary standard. The so-called monetary standard is the benchmark or "anchor" of the currency, generally referring to heavy metals, or reserve currencies. For example, the currency board system currently adopted in Hong Kong has the US dollar as its monetary standard. The currency under the monetary standard can be issued by the central bank, but in history it was often issued by commercial banks, and the number of issuers tends to converge. The third category is the credit currency system. The global monetary credit system is generally believed to have been formed with the collapse of the Bretton Woods system in the early 1970s. Governments or central banks of various countries monopolize the issuance of legal tender, which has no tangible support but relies solely on the credit support of the government.

The emergence of the credit currency system was not triggered by a certain technology, but was the result of the natural changes brought about by economic development to the monetary system. After the Second World War, the global economy entered a golden age of rapid development, and the global economic structure underwent major changes. That is, as the proportion of the post-war Japanese and Western European economies in the global structure gradually increased, the gold exchange system anchored by the US dollar could no longer adapt to this structure. The so-called "Triffin" dilemma led to its collapse and inadvertently led to the emergence of a comprehensive modern credit currency system. The most important feature of the modern monetary system is that the issuance of currency does not require any material support, but relies purely on the credit support of the government, and the government's credit is implemented by the government's coercive force. Therefore, the issuance of such currency adapts to the globalization of the economy and the relatively high speed of economic development.

The emergence of the global credit currency era has overturned some of the previous people's understanding of financial and monetary laws. For example, the theory of monetarism was popular in the 1960s and 1970s, but its defects have now been pointed out by more and more people. Inflation is not entirely a monetary phenomenon. Money is very relevant to the real economy, but it is not strictly one-to-one. To make an analogy, if the amount of money is compared to a rubber band, it has a certain elasticity, but this ability is also limited. If it is pulled too hard, it will break. Similarly, too much money may cause inflation or asset price bubbles. In addition, the "Gresham's Law" we are familiar with, that is, bad money drives out good money, this rule is only applicable to the era of precious metals. But in the era of credit currency, it is a universal law that good money drives out bad money or that strong credit money drives out weak credit money.

This situation has created the prerequisite for the central bank to play a greater role in macroeconomic regulation. The Fed led by Volcker to control high inflation in the 1980s is a successful case. It can be said that the emergence of the credit currency system has promoted the formation and improvement of the modern central bank system.

The formation of modern central banking system

Historically, the world's first central bank was the Swedish Central Bank, established by the Swedish government in 1659. The emergence of central banks is an inevitable result of social and economic development, and a natural result of the evolution of commercial banks. In the 17th and 18th centuries, the Industrial Revolution had begun to sweep the world, and commercial banks came into being. Commercial banks issue commercial bills, and the exchange and clearing of bills requires a neutral and independent institution to carry out. Commercial banks implement a partial reserve system, which may also lead to bank runs and bankruptcies, which also requires an independent and powerful institution to clean up. Central banks emerged in this situation, so they are often called "The Last Resort of Credit."

The central bank of the United Kingdom has a greater impact on the world. In 1694, William III, who ascended to the throne through the Glorious Revolution, approved the establishment of the Bank of England. When it was established, the Bank of England obtained the right to issue currency on the condition of providing loans to the government. In 1844, according to the Peel Act, the Bank of England monopolized the issuance of banknotes, gradually monopolized the right to issue national currency, and became the only currency issuing bank in the United Kingdom in 1928. Monopolizing the issuance of legal tender can be said to be a core function of modern central banks.

In addition to the above reasons, the establishment of central banks in various countries is also closely related to the country's social and economic system and economic development stage at that time. Here are two interesting cases, namely the establishment and development of the central bank of the United States and the central bank of China before liberation. The two central banks were established at almost the same time. In 1913, the U.S. Congress passed the Federal Reserve Act, and the Federal Reserve Bank of the United States was established in 1914. In 1904, China (Qing Dynasty) established the Ministry of Revenue Bank, which was also the central bank. In 1908, the Ministry of Revenue Bank was renamed the Bank of Qing, with its headquarters in Beijing. In 1911, after the outbreak of the Xinhai Revolution, it was renamed the Bank of China. Although the two countries established central banks at similar times, their social backgrounds were completely different. The United States has tried to establish a central bank three times in more than 100 years (they were the Bank of North America in 1781, the First Bank of the United States in 1791, and the Second Bank of the United States in 1861), but all ended in failure. There are many reasons for this, but the main reason is that the United States is a federal country, each state has its own interests, and the conflicts of interest between various parties in various places make it difficult to establish a unified central bank across the country. The chaos of state regulation allowed private banks to profit from it. In 1907, the United States suffered an economic panic, and finally had to use a compromise method to establish a central bank by setting up regional branches. With the establishment of the Federal Reserve, the competition for currency issuers that lasted for more than a century finally came to an end. This not only enabled the United States to continue to develop rapidly after becoming the world's largest economy, but also played a vital role in the establishment of the dollar's global dominance. China has been in a semi-feudal and semi-colonial social environment for a long time in modern times. Therefore, although the central bank was established at that time, it did not really monopolize the issuance of currency afterwards. At that time, the warlords' melee led to political instability. All commercial banks, including foreign banks, could issue currency on their own, causing great chaos and having a huge negative impact on China's economy. It was not until the 1930s that China implemented the currency system of "abolishing the two-yuan system and changing the yuan" and carried out legal currency reform. At this point, the central bank truly mastered the right to issue currency and became a central bank in the true sense.

From the practice of various countries, the central bank system presents some common characteristics in terms of historical evolution, basic goals, governance structure, etc., but they are not completely the same. In 1983, the State Council decided that the People's Bank of China would exclusively exercise the functions of the central bank. In 1995, the "Law of the People's Bank of China" was officially promulgated, marking that my country's central bank system has entered a new stage of legalization and standardization. Since the 18th National Congress of the Communist Party of China, the Party Central Committee and the State Council have made new regulations on the configuration of the functions of the People's Bank of China, strengthened the responsibilities of the People's Bank of China in macro-prudential management, systemic financial risk prevention, and coordinated supervision of financial infrastructure, so that my country's central bank system is more in line with the needs of high-quality development. At the same time, it should be noted that after long-term development and reform, my country has become a financial power, the situation of national financial security and stability is complex and severe, financial technology has profoundly changed the financial industry, and the construction of a modern central bank system faces many new opportunities and challenges. The Fourth Plenary Session of the 19th CPC Central Committee proposed the construction of a modern central bank system from the perspective of promoting the modernization of the national governance system and governance capabilities. The Fifth Plenary Session of the 19th CPC Central Committee made strategic arrangements for the construction of a modern central bank system based on promoting high-quality development and coordinating development and security, which is of great significance.

On October 23, 2020, the "People's Bank of China Law of the People's Republic of China (Draft for Comments)" incorporated macro-prudential management and supervision of systemically important financial institutions into the responsibilities of the central bank, which will help build a modern central bank system. The draft revision also stipulates that the RMB includes physical and digital forms, which will provide a legal basis for the issuance of digital currency.

Yi Gang, governor of the People's Bank of China, published an article titled "Building a Modern Central Bank System" in the "Guidebook to the CPC Central Committee's Proposal on Formulating the 14th Five-Year Plan for National Economic and Social Development and the Long-Term Goals for 2035", which elaborated on the significance, connotation and major measures of building a modern central bank system. The modern central bank system is the sum of the modern monetary policy framework, the financial infrastructure service system, the systemic financial risk prevention and control system and the international financial coordination and cooperation governance mechanism. The goal of building a modern central bank system is to establish a central bank system and mechanism that helps achieve the four major tasks of currency stability, full employment, financial stability and balance of international payments, manage the overall monetary gate, provide high-quality financial infrastructure services, prevent and control systemic financial risks, manage external spillover effects, and promote the formation of a fair and reasonable international financial governance pattern.

The origin, positioning and prospects of digital currency

Starting from an article written by Satoshi Nakamoto in September 2008, Bitcoin has soared in just over 10 years. As of February 19, 2021, the price of Bitcoin has reached a high of $56,000, and the total market value has reached the $1 trillion mark. The emergence of Bitcoin is not accidental. After the outbreak of the global financial crisis in 2008, in order to save financial institutions on the verge of bankruptcy and stabilize the financial market, central banks in developed countries implemented unconventional monetary policies and issued a large amount of currency, and market confidence in currency fell to a low point. The basic meaning of currency is to provide liquidity and facilitate transactions between economic entities, which is specifically reflected in its three basic functions of pricing, exchange and value storage. People look at currency mainly for its reliability and stability. At that time, people paid more attention to the stability of legal tender issued by various countries, that is, whether its value is reliable. Correspondingly, Bitcoin uses blockchain as the underlying technology, adopts a decentralized distributed electronic accounting system, and issues a fixed amount of 21 million bitcoins in an attempt to indicate the stability of its value. But in fact, not to mention that due to hacker intrusions, some accounts have had their bitcoins stolen several times, and criminals have used bitcoins to launder money, the main reason why people cannot generally use bitcoins is that its value fluctuates greatly, like a roller coaster, and can appreciate or depreciate by more than 20% a day, which cannot meet people's requirements for currency stability. More than a decade has passed, and Bitcoin still cannot become a currency that people can use. In response to such a defect, stablecoins, which are also based on blockchain technology, have emerged. Stablecoins are linked to existing legal tender in some form to maintain the relative stability of their value. Among them, the most eye-catching is Facebook's Libra. Facebook published the first version of the Libra white paper in 2019 and the second version in 2020. Although Libra has attracted everyone's attention due to its large number of users and wide interfaces for franchised enterprises, it still encountered "difficult birth" because it challenges the sovereignty of legal tender issued by various countries.

Under such impact and influence, central banks of various countries began to consider the use of digital technology to issue their own digital currencies (Central Bank Digital Currency, referred to as CBDC). According to the survey of the Bank for International Settlements, many central banks in many countries are currently studying CBDC, but most of them are still limited to the scope of conceptual frameworks, and not many are actually put into production or trials. According to the results of various studies, CBDC has the advantages of reducing the cost of currency issuance, improving the efficiency of currency transactions, and promoting inclusive finance, the transmission mechanism of monetary policy, and the convenience of cross-border transactions. Especially in the field of payment, it may have more advantages than the existing mechanism. The Federal Reserve once conducted a study that compared and demonstrated from seven aspects, namely accessibility, anonymity, bearer instrumentality, independence, operational efficiency, programmability, and service availability. The study pointed out that it is impossible to benefit from all seven aspects at the same time. CBDC is essentially different from private currencies such as Bitcoin and Libra. Although both use digital technology, CBDC and private digital currencies are not on the same track. CBDC is actually an extension of conventional and traditional sovereign legal tender on the axis of time and technology. It is a digital legal tender, so it has the basic functions of legal tender, whether it appears in the form of cash or in other forms, which is a basic feature that distinguishes it from private digital currency. Although private digital currency is also in the form of digital technology, it actually has more attributes of assets. People buy private digital currency to a large extent to hedge against possible currency depreciation and to maintain value.

There is a view that, as has happened in history, multiple currencies can coexist, and the central bank's digital currency and private digital currency can coexist in society and circulate at the same time? As mentioned earlier, after many countries have tried and failed at different times, currency has moved from physical to credit, and the issuance of currency has become increasingly centralized, moving towards the monopoly of the central bank. History has clearly shown that the past situation of multiple currencies co-circulating has come to an end, just like the gold standard, which is unlikely to return. There is also a view that CBDC may bring about fundamental changes in cross-border transactions of currency. CBDC is undoubtedly conducive to cross-border transactions, but the current high costs and inconvenience of cross-border capital transactions are not caused by technical difficulties, but by different institutional arrangements. Specifically, because each country has different levels of capital control, even countries that do not implement capital controls have certain restrictions on the amount of cash that can be carried out of or into the country, and this cannot be solved by digital currency.

In short, both personal digital currency and CBDC are new things that are emerging, and we can conduct a lot of research, experiments and observations. From what we have observed so far, private cryptocurrencies represented by Bitcoin have become and will continue to become an asset; global stablecoins represented by Libra are unlikely to become supranational global currencies. But if it takes a step back and does not aim to become a currency, but only serves as a payment platform, then its impact on the financial system will also be huge; as for the future of CBDC, it depends on how the central bank designs it. If a wholesale model is adopted, that is, the current structure of individual accounts-commercial banks-central banks remains unchanged, it is a safe approach, and the impact on the financial system will be marginal; if a retail model is adopted, that is, individuals/enterprises are allowed to directly establish accounts in the central bank, there will be many difficulties in terms of technology and stability, but it may have a significant impact and impact on the financial system.